At the end of Q4 2013, SolarCity Corp. (NASDAQ:SCTY) reported a forecasted retained value of $1.052B. As we have discussed in our earlier article on this subject, solar technology is in its early stages with little operating data to support 20 to 30 year predictions. To reduce investment risk, it is incumbent on investors that these numbers be scrutinized to get a realistic assessment of the company's prospects.
In this article we look at two assumptions on how SCTY reports the retained value. The first assumption is that the default rate for customers buying solar leases and PPA is comparable Auto Loans or Prime Mortgages thus justifying a 6% discount rate. The second assumption is that customers will renew at a rate equal to 90% of the contract rate.
"We took a look at the assets, comparable asset classes that the consumer would use from auto loans to prime mortgages and compare to default rates and the payment history, and this asset class is traded between 4% and 6% and we break the upper end of 6% as what we would utilize even though the default rates and predictability of cash was higher in both of those asset classes. So that's how we came up with quote marking our portfolio to mark at 6%."
"'Retained Value Renewal' represents the forecasted net present value of the payments SolarCity would receive upon Energy Contract renewal through a total term of 30 years, assuming all Energy Contracts are renewed at a rate equal to 90% of the contractual rate in effect at expiration of the initial term."
These two assumptions, we believe, are examples of questionable thinking that is going into computing retained values. Let's look at each of the assumptions:
Customer default rates
SCTY management compares its leases and PPAs with auto loans and mortgages and expects SCTY customer default rates and cash flow metrics to be better. SCTY management uses this argument to justify a 6% discount rate. But is this argument really valid?
Auto loans and prime mortgages have default rates in the 0.5% to 2% range. But one has to consider that most auto loans are for a duration of 3 to 5 years. And, most mortgages, even if they are for up to 30 years, get refinanced on average about 5 to 7 years. The reason being that customers refinance if they can get better rates. Herein lies the first problem.
Will SCTY customers have an option to terminate their PPA and get a competing solution when they see that solar energy is getting much cheaper and they can get significantly lower energy rates from competing vendors? The answer is "no." What this dynamic is going to do is create a situation where, with passage of time, customers will see that the energy rates they are paying SCTY are far worse than the energy rates being offered in the market. Another potential problem arises when SCTY customers try to sell their homes - savvy buyers may see the lease/PPA as a liability and not an asset.
Twenty years is a long time for customers to continue to take this aggravation. The likely result? Customer sabotage, default and other undesirable customer outcomes. For those who doubt this dynamic consider that in a contract as solid as a marriage, people go looking for better/younger options in a time period far less than 20 years. You think a PPA can't be sabotaged or broken?
With this backdrop, will SCTY products have default rates comparable to auto loans and prime mortgages? We find this highly unlikely. Reasonable people can disagree on what the default rate is likely to be but we expect a default rate in excess of 10% - a far higher rate than what auto loans or prime mortgages would incur. If you agree with this logic, then the extension is that customer maintenance and "truck roll" costs of a dissatisfied customer base would be far in excess of what SCTY is modeling.
Energy Contract Renewal Rate Factor
As we already pointed out, SCTY is modeling customers would renew the energy contracts, after 20 years, at a rate that is 90% of the contract rate. The wishful thinking displayed in this assumption is beyond mind boggling.
To understand this better, one needs to look at the current LCoE rate and trends. It is well known that LCoE rates for solar installations are dropping like a rock due to system cost decreases and finance cost reductions. A residential customer with access to low-cost financing could easily achieve an LCoE of about $0.12 per KWh compared to the $0.15 to $0.17 per KWh that SCTY currently offers. As system costs drop, these LCoEs are likely to drop below $0.10 in five years and could be around $0.05 or lower by the time current SCTY agreements end.
As time passes, SCTY customers who are stuck with a high price contract will likely be dissatisfied with what they are paying SCTY. By the time the existing contracts come to an end, these bitter customers may not consider extending the lease and, worse, do everything in their power to sabotage or undercut SCTY. Savvy customers could even ask for an extension rate that is below the then prevailing PPA rates because they would know that the alternative or SCTY is to incur labor expenses to dismantle the existing system.
Again, reasonable people can disagree on what energy rate is appropriate to model in that time frame. We estimate that a generous number for SCTY to use here would be a rate equal to 50% of the original contracted rate. And, that may be extremely generous.
Based on these two factors alone, even if we were to use very generous allocations for default rates and terminal prices, we estimate that SCTY's retained value is overstated by at least 20% and likely significantly more. While the actual default rates and energy rate discounts will not be known for another decade or more, it is hard to ignore the effect these factors have on retained value.
Given the nascency of the solar industry, a conservative approach is warranted in modeling default rates and terminal energy prices. Unless we have missed something fundamental in SCTY's operational model, the assumptions stated in current SCTY financials are at best wishful thinking.
We welcome readers to present their view on reasonable default rates, discount rates and energy prices 20 years out.