- SolarCity's response to the solar tariffs indicate the company was well-prepared for the decision, and the cost impact on SolarCity should be transitional and minor.
- However, SolarCity continues to face substantial long-term headwinds to its business model.
- Using proper assumptions, we believe the company may be overvalued by about a factor of 10.
Lately, there has been much furor about the US solar tariffs and how they impact the US solar industry. SolarCity (NASDAQ:SCTY) is one company that is directly impacted by the tariffs, and the company's response to the Commerce decision was swift.
As a healthy sign of preparedness, the company announced within a day of the Commerce decision that it has added REC Group as its module supplier. This agreement covers only a quarter to half of SolarCity's current needs, so we fully expect SolarCity to announce addition of other suppliers to fill the future supply gap. REC Group is not known to be competitive with Chinese solar pricing, so it is likely that SolarCity will have a small cost hit from the REC agreement - likely in the range of $0.05 to $0.10 per watt.
First Solar (NASDAQ:FSLR) (see thesis) could have been a possible low-cost module choice, but its products are not compatible with the Zep Solar mounting system that SolarCity is committed to. To avoid the tariffs, SolarCity has to source products with a supply chain that is entirely not from China, and that vendor has to be Zep Solar-compliant. These limitations severely narrow SolarCity's choices, and are likely to increase procurement costs for SolarCity.
While the cost increase from this supply adjustment is a slight negative, for a typical SolarCity investor, it seems that the additional resulting losses do not matter. Unfortunately, some investors genuinely believe higher losses are sign of a superior company, and some others are sold on the company kool-aid called "retained value".
We have railed in the past about SolarCity's retained value shenanigans. The number and type of assumptions that need to be made over the 20-to-30 year time frame makes this type of valuation a relatively meaningless exercise. See our thoughts about the absurdity on this approach here.
In addition to any short-term impact from the Commerce decision, a long-term investor should consider that there are several trends that work against SolarCity model that make it unappealing. These include:
- Reducing government incentives
- Increasing competition and reducing margins in an industry with low barriers to entry
- Decreasing cost of solar, which make it more affordable for homeowners to buy than lease
- Reducing marginal value in each installation due to decreasing prices
- Competition from other loan products (see recent poll where customer show 2:1 preference to take a loan than lease)
Even if an investor were to ignore all these negative factors and assume a rosy path ahead for SolarCity, a meaningful valuation model would be necessary to estimate the company's value.
To build a valuation model for SolarCity stock, one of the critical factors to take into consideration is the company's asset model. SolarCity's asset model is akin to building a structure on a leased land. One can build a structure on leased land and operate it profitably, but at the end of the lease term, the negotiating power resides firmly with the land owner. The entity that built or operated the structure has very little negotiating power at the end of the lease term. SolarCity's solar asset situation is no different, whether the assets are ground-based or rooftop-based.
Given this kind of asset, an appropriate way to value solar project companies such as SolarCity, SunPower (NASDAQ:SPWR) (see thesis here) and SunEdison (NYSE:SUNE) (see thesis here) would be based on either of the following two asset types:
- The biggest difference between the asset types is that real estate appreciates, whereas solar systems depreciate and are nearly worthless at the end of 20-year lease term.
- REIT depreciation can be added back, but solar asset depreciation cannot be added back for valuation purposes.
- ITC effects need to be considered in cash flow calculations.
- Durable equipment leasing business
- In terms of asset types, this model is a better parallel to solar assets than a REIT model
- To get a closer approximation, one should only consider businesses that operate with long-term leases (10-year plus)
- ITC effects need to be considered in cash flow calculations
It is difficult to value SolarCity using either of these methods due to the way SolarCity presently discloses material information. Unfortunately, the company is guiding investors to choose an unproven, high-risk model with erroneous assumptions that dramatically overstates the company's real earning potential.
In this article, we will go along with the company's retained value approach and attempt to compute the company's value using a more rational set of assumptions than the assumptions that the company makes.
The company breaks its retained value into two components" "retained value under energy contract" and "retained value renewal". For our valuation model purpose, we take the company's first metric as is, and break the second metric into two parts. Here is the prognosis for the three components of SolarCity's retained value:
Prognosis for lease dynamics for the initial 20-year lease term
Company's current stated "retained value under energy contract": $840M
The company does not state the assumptions for this component, but states that it expects the defaults to be less than car loans and prime mortgages. We disagree, and we have written about the fallacy of this assumption in our past articles. Our assumptions are as follows.
In an unusually aggressive disclosure practice, SolarCity includes value from booked yet unbuilt business). We have no easy way of backing out the retained value from the booked yet unbuilt business. So, we will leave that aspect alone.
The retained value number is based on a 30-year amortization schedule that we find wildly optimistic - especially considering lack of any goodwill or leverage at the end of the 20-year lease term. Our assumption on amortization period for the deployed solar energy systems: 20 years.
Renegotiations/default rate by the end of 20-year contract: This is where the biggest unknown of the company's business model. The renegotiation/default rates are difficult to model, as the timing and impact of these events is not easily predictable.
Adjusting for the default rate and amortization schedule, our estimate of "retained value under energy contract": $300M to $600M
Computing these numbers is difficult, because very little of the data required to compute these calculations exists in the public domain. Regardless, we believe this estimated number is an optimistic outcome for SolarCity.
Prognosis for lease renewal past the initial 20-year lease term:
Company's current stated "retained value renewal": $451
For a background to this component on retained value and a detailed discussion of the key components, please see our article here. Our assumptions on this component are as follows:
Percentage of systems likely to be operational at the end of the initial 20-year lease term: 80% (optimistic estimate)
% of customers who are likely to renew at the end of the 20-year lease: 50% (depends on renewal pricing, roof condition, and desirability of the system in 20 years)
Value of retail solar energy at the end of 20 years: 30% of initial contract value (~$0.05 per KWH)
Energy output at the end of 20 years: 80% of initial rating
Approximate retained value as a percentage of company's currently stated residual value number: 12%
Our estimate of "retained value renewal": ~$50M
Assuming a 20-year lease life time, SolarCity would need to uninstall its systems 10 years earlier than the assumptions built into financials. SolarCity does not disclose the nature of amount of these expenses, other than to identify the risk with the variability of these expenses. We agree that these expenses are difficult to estimate given the variability of roof types, ages of roof, labor expenses, any future recycling costs, etc. Our estimates below are once again in favor of SolarCity and likely optimistic.
Uninstallation/Recycling/Warranty costs at the end of lease term: $0.25 per watt
Residual value of the uninstalled solar panels at the end of lease: $0.12 per watt
Net retained value at the end of lease term: ($0.13) per watt
Our estimate of negative end-of-life adjustments: ~($50M)
When we combine the above three items, we get a net retained value estimate of $300M to $600M (including unearned bookings). However, this number does not account for the negative earnings that SolarCity has posted in the past.
From the most recent balance sheet, we can see that the company has a "retained earnings" (this is a GAAP balance sheet item and different from "retained value") of ($226M). If one were to adjust for the retained earnings to account for the unearned bookings discrepancy, the adjusted retained earnings could be approximately ($250M).
In other words, the net value likely to be generated by the company to-date is approximately $50M to $350M.
While there is substantial amount of guessing involved in arriving at these numbers, for an investor, the $50M to $350M range is likely a lot more realistic than the company stated retained value of $1.29B.
So, what is the value of a company that has generated $50-350M of value in its entire existence (including unearned bookings)? Is $4.59B a reasonable number? Investors can decide what the company is worth to them, but we believe the answer is closer to $350M than $4.59B.
There is no question that all assumptions in this article are subject to debate. Reasonable opinions can and will vary. While the bulls may disagree, we believe the assumptions used are optimistic in favor of SolarCity. Less favorable assumptions can push the company's net value generation to a negative number. We leave it as an exercise to the readers to make assumptions they like and post the valuation results in the comments section.
Regardless of the assumptions used, valuing SolarCity or any other solar project company based on retained values is an exercise in futility. The retained value is subject to wide variations, depending on the assumptions that will unfold over a 20-to-30 year time span. All things considered, we believe that SolarCity merits a valuation closer to its net asset value until the quality of its disclosures warrant a revision. A sane valuation for this stock would be less than $10 a share.
Our Sentiment: Avoid