Analyzing Rooftop Solar - Is This Asset Class Really A Ticking Time Bomb?

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Includes: RUN, SCTY, SUNEQ, TSLA, VSLR
by: Aurelien Windenberger

Summary

Over the past few years, residential rooftop solar installers such as Solar City, Vivint Solar, and Sunrun have grown at tremendous rates, as customers have gone solar w/no money down.

Some analysts have argued that rooftop solar is actually a terrible deal for the customer, which makes the companies' operating assets ticking time-bombs.

I wasn't sure I agreed with their assessments, so I ran the numbers myself. It turns out that a consumer's tax situation has a large impact on the outcome.

Residential solar stocks have been on a serious rollercoaster over the past month. After Congress passed the ITC credit extension in mid-December, Solar City (NASDAQ:SCTY) and Sunrun (NASDAQ:RUN) both saw their stocks double in the space of a week. Rival Vivint Solar (NYSE:VSLR) saw a smaller increase since they are in the process of being purchased by SunEdison (NYSE:SUNE).

SCTY Chart

SCTY data by YCharts

The price increases were predicated on the idea that the ITC credit extension expanded the runway for further installation growth out an additional five years. However, investor attention has quickly turned towards the increasing headwinds face by the industry. These headwinds include:

  1. 2016 sales growth is likely to be disappointing, given that potential customers will now face less urgency to make their purchase decision thanks to the five-year ITC extension.
  2. State utility boards are examining current rate structures and in many cases updating them to account for distributed solar's impact on the grid. In certain states, such as Nevada, those decisions have been strongly against solar customers. Fellow contributor Enertuition even argues that this is the template for the future.
  3. Finally, other analysts have also argued that solar leases are a terrible deal for consumers. Fellow contributor Rogier van Vlissingen has written about this topic multiple times, including his excellent recent piece in late December.

While these strong headwinds have been well articulated by others, I wasn't sure I agreed with notion that they make the residential solar installers a poor underlying investment. While they might be overvalued at their recent highs, it seemed likely that they were worth something more than zero. As such, I decided to explore the headwinds myself.

Low 2016 Growth

As noted, many believe that 2016 installation growth will be weak, due to the drop in urgency now that the ITC credit has been extended. While this is a short term negative, its important to note that growth is still expected by the industry. I expect Sunrun and Solar City to update shareholders with their current expectations at their Q1 earnings calls, and both companies will almost certainly project higher MWs of installations than in 2015.

I also see slowing growth as a good thing, as it will have the effect of lowering acquisition costs. Sales costs have averaged over $.60/W at all installers due to their desire to grow as quickly as possible. Solar City has noted that they expect to see these costs drop to $.40/W over the next couple years, as slowing growth allows them to stop spending money on the marginal sales channels.

Utility Boards Change Their Rates

This is likely the largest headwind for solar leases going forward. As leases have become more popular, utilities are undoubtedly beginning to see the effects on their bottom lines. Almost every state currently has net metering rules in place for customers of their publicly traded utilities. As installation costs have decreased, more consumers are in a position to save money by adding rooftop solar.

When a consumer adds rooftop solar but remains on the grid, the utility ends up acting as a battery for the consumer, taking their excess energy during peak production hours, then returning it to the consumer during the evenings and winter season. Thus, the utility sees a drastic drop in revenue from that consumer, but no drop in the maintenance costs associated with the consumer.

Utilities, such as Nevada's NV Energy, have argued that if this trend continues, the impact will be felt by continuing utility customers; those that are too poor or located in places where solar panels can't be added. Nevada's public utility commission (PUC) agreed, and voted for a new solar tariff structure in late December that plans to reduce current net metering rates over the next four years.

The big surprise in the decision was that existing customers were not going to be grandfathered into their existing rates. This left customers in a terrible situation of having made a purchase decision based on existing economics that got totally wiped out by the new rates. The backlash was predictably huge, and the Nevada PUC has recently decided to revisit their decision not to grandfather existing systems.

Personally, I believe that it is only fair to grandfather in existing solar customers. Utility boards should also adjust their rates structures to make things fair for all consumers. These decisions will likely continue to make it harder for solar installers to present potential new customers with an economic benefit at current cost structures. However, I do expect them to be able to adjust their business plans over time.

Solar City is in particularly reasonable shape on this front, given their ability to offer Tesla's (NASDAQ:TSLA) Powerwall battery. As Tesla's Gigafactor ramps up production and delivers lower battery prices, markets for off-grid solar+battery will begin to open up. Tropical locations such as Hawaii and the Caribbean already have the right combination of consistent sun and high grid prices.

Are Solar Leases Really a Terrible Deal for Consumers?

The biggest argument made against Solar City and company may be that their solar leases are terrible deals for consumers. As noted earlier, Rogier van Vlissingen has argued that this is the case many times, while Paulo Santos has also recently explained why he believes that solar leases are second mortgages and residential installers are sub-prime lenders.

Rogier and Paulo make great arguments, but I believe that they are overstating the negatives of taking on a solar lease, and giving no credit to the real benefits seen by many consumers. As such, I decided to run some scenarios myself to see just how bad a deal a solar lease might be.

Any scenario is only as good as one's assumptions, and as such, I'm presenting mine below. I've also submitted my spreadsheet with this article, so that interested parties can play with my assumption.

Based on the above, I looked at the total out-of-pocket cost to a homeowner over a 20 year period under a variety of scenarios. This period coincides with the standard solar lease period. My base assumption is that the current utility rate is $.19/kWh, and that a solar lease would start at $.13/kWh. I assume that the lease rate increases by 2%/year, while the utility rate either stays flat (my base assumption), or averages a 2% increase, or decrease, annually over the period.

Click to enlarge

As seen above, the most expensive option in all cases is not adding a solar system and simply paying the utility for power. Even in the scenario where utility costs drop 2%/year, adding solar today is still a positive economic decision. Under my base scenario, flat utility rates over the period, adding solar is a decision that will save the customer between 16% and 38%.

Buying the system outright will clearly lead to the lowest out of pocket expense for the customer, assuming that they can take full advantage of available tax credits. Customers that can't take advantage of these credits themselves would actually end up spending a similar amount of money as if they took on the 20 year solar lease. Considering the fact that over 45% of households end up paying no income tax on their federal returns, there is actually a huge population that would see little to no net benefit to owning the panels on their roof vs leasing them, at least based on my scenario.

Based on this outcome, it seems that the decision to own or lease comes down to personal circumstance. There are many cases where it would be crazy to lease rather than own, and likewise many where leasing means no money down and minimal to no lost economic benefits. While do it yourself types with large enough income tax loads would likely be able to save even more than I've laid out above, the typical consumer may benefit most from the simplicity of having someone else own and manage the panels.

Skeptics such as Rogier would certainly argue that the consumer will be hurt when they go to sell their home, given that the buyer would be required to take on the solar lease. Quoting from his recent article:

July saw the publication of a study from Arizona State University, concluding that leased solar systems were causing a 3-8% discount on home sales, whereas owned systems resulted in a 4-6% premium.

Assuming the results hold nationally, this is clearly a potential issue for any solar lease owner. Yet, there also seems to be a simple solution; the homeowner can purchase the solar panels. Depending on the cost of the home and the size of the system, buying out the lease could help the homeowner recoup much of the supposed loss.

Average US Home Sale $225,000 $400,000
Solar Owned Home (4%) $234,000 $416,000
Solar Lease (-4%) $216,000 $384,000
Difference owned vs leased $18,000 $32,000
Click to enlarge

The average system size installed by the residential solar companies is 6-7kW. Assuming a 7kW system and a discount rate of 6%, the installer would be happy to sell the system to the customer for no more than $15,000, and potentially less, depending on how long is left on the lease at the time. For someone in an expensive home area, this would be a net positive, while someone in a lower cost area would take a bit of a loss. However, the net result is not nearly as bad as people have described. The customer is paying much more in transaction and moving costs, compared to the money lost on the system.

Conclusion

While rooftop solar has multiple headwinds, I believe that they have all been over stated. As such, I believe that the industry will likely see continued growth over time. I also expect that current solar lease assets will end up being nearly as safe as currently projected by the solar companies. That said, this only applies to the initial 20 year contract term.

Based on my analysis thus far, I plan to spend more time reviewing Solar City and Sunrun to come up with a valuation for their stocks. Both looks over priced in late December, but might be reasonably valued at current prices.

My analysis thus far is by no means complete, and thus I welcome dissenting opinions and would love to see you break down your rational.

Disclosure: I am/we are long SUNE.

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.