SCTY Deep Dive: Will Any Residential Solar Leases Actually Get Renewed After The Initial 20 Year Lease Term?

| About: SolarCity Corp. (SCTY)

Summary

One of the core assumptions made by residential solar companies is that most of their customers will choose to renew their contracts after the initial 20 year lease.

The NPV of these renewals is typically 10-15% of total calculated NPV, and is a crucial portion of the installers' final profit calculations.

Skeptics believe that the installers have grossly over-estimated the amount of customers that will actually renew, and thus are overstating the value today.

Once again, I believe the reality is more nuanced than either side is willing to admit.

Note: I'm doing a small series of articles delving into some of the key issues to consider when trying to figure out the value of residential solar installers like SolarCity (NASDAQ:SCTY). My first article explained why I believe that the solar lease model will be alive and well for another 4-5 years. In this article, I start looking at the economics from the installer's point of view.

For those of you not already in the know, residential solar installers such as SolarCity, Sunrun (NASDAQ:RUN), and Vivint Solar (NYSE:VSLR) have a relatively simple proposition for customers: Let us install a solar system on your roof, then lease if from us for the next 20-30 years. You'll pay $0 down and have a lower rate than what you currently pay the utility.

This model has greatly popularized residential solar, leading to tremendous installation growth over the past 5-7 years. It also means that the companies involved are spending money up front in exchange for a projected stream of cashflows over the next 20-30 years. The initial lease term is typically 20 years, with the customer then able to decide whether or not to extend the lease for another 5-10 years.

One of the core assumptions made by residential solar companies is that most of their customers will in fact choose to renew their contracts after the initial 20 year lease. The company's justify their projections by noting that they plan to entice customers to stay on by giving them a 10% discount to the rate the customer paid in the last year of the initial contract. So if year 20 cost the customer $.20/kWh, then year 21 would drop down to $.18/kWh. With utility rates projected to be in the mid-$.20s/kWh, what customer wouldn't want to stay?

Almost all of them, say skeptics. They believe that the installers have grossly over-estimated the amount of customers that will actually renew, and thus are overstating the value today. Should customers choose not to renew, installers would lose out on a meaningful portion of their current projected NPV, which is potentially the difference between a positive and negative return on their efforts.

Using SolarCity as an example, during the last three quarters, the company calculated the following:

Net cost and present value (@6%) Q2 2016 Q1 2016 Q4 2015
Total Cost per Watt $3.05 $3.18 $2.67
Total NPV per Watt of MW Deployed $3.62 $3.46 $3.64
Contracted NPV per Watt $3.26 $3.13 $3.32
Renewal NPV per Watt $.36 $.33 $.32
Click to enlarge

We can see that during the 1st quarter of 2016, SolarCity's contracted NPV/Watt ($3.13) is actually a few cents less than its total installation cost/Watt ($3.18). Thus, its relying on the value of the renewals to generate an positive outcome for the quarter. During Q2, the numbers are better, but a large portion of the projected positive NPV is still based on the renewal value.

The company did much better during Q4 2015, where they spent only $2.67/Watt and yet have a contracted NPV of $3.32. Even in this case, the renewal NPV comes out to about 33% of the total positive projected NPV. Given all this, its no surprise that a big deal is made regarding what will happen when these contracts are up for renewal.

So what's going to happen in 20 years?

This is of course the million dollar question. Solar installers project that utility rates will continue climbing at 3% a year, as they have the past 20-30 years. Thus they assume that customers will be happy to renew for another 10 years at a 10% discount to their year 20 PPA rate.

Skeptics argue that with solar installs continuing to become cheaper and panels becoming better looking, no one is going to want to keep a 20 year old system on their roof, and as such, SolarCity is going to have to remove all the systems from the customer roofs at great expense.

I believe that both sides are assuming extreme scenarios. It's clear to me that the decreasing cost of solar and wind, along with decreasing battery storage costs, make it extremely likely that electric rates in 20 years will not be higher than today. In fact, my assumption is that they will be lower, particularly in high cost states like California.

This is a negative for installers hoping that customers will renew their solar leases, since the $.13/kWh starting lease rate will have climbed over $.20/kWh by year 20. Right now, installers such as SolarCity are expecting to be able to renew these leases at rates that will average $.19-.21/kWh over years 21-30. Based on continuing declines in costs, I'm certain no customer will be willing to renew their leases at those prices.

However, I'm also a firm believer that most customers will be happy to extend their lease contract, IF the price is right. While detractors will argue that every customer is going to be so angry with SolarCity after 20 years that they will just want the panels off, I believe that most customers will actually be happy to keep paying for power, as long as they are getting a decent deal.

After all, by extending the lease, the customer gets to continue benefiting from the power, without any of the potential hassles of owning a 20-year old system. SolarCity will be replacing the inverter if required, and continue doing any needed maintenance.

How low will the new lease rate be?

I believe that the new lease rate will need to once again be reasonably lower than the utility rates at the time, and lower than the cost of installing a brand new system at that time. The table below shows a couple of different examples of how low the new rate might have to be, and how SolarCity's NPV today would be affected:

Utility Rate/kWh in 2036
Click to enlarge
SCTY required renewal rate Net Present Value to SolarCity
$.20/kWh $.18/kWh $.36/W
$.12/kWh $.10/kWh $.18/W
$.08/kWh $.07/kWh $.09/W
Click to enlarge

Clearly, lower renewal rates would have a negative effect on the NPV of the renewal for SolarCity, knocking as much as 75% off the value if we saw utility rates drop about 35-40% from today's average levels. At this point, the renewals have little value to SolarCity, even if the customers are happy to renew.

The actual long term benefit to SolarCity

I think its clear that on a NPV basis, its unlikely that lease renewals will be of much value to SolarCity. There is however, another factor which will potentially be worth substantially more, which is the value of the customer themselves.

At this point, SolarCity has over 300,000 customers on solar leases. As these leases come up for renewal, the company will have the opportunity to sell each customer on a variety of upgrades or new products, some of which aren't even available yet.

Since going public, SolarCity's acquisition costs have ranged between $2,500-$5,000/customer. These high costs have been a big part of why the company keeps showing losses today. Yet they also mean that over the next 20-30 years, the value of each existing customer could easily be $1,000-2000, as much or more than the currently calculated NPV of the customer's potential contract renewal.

This customer value is something that is currently overlooked by detractors. Clearly, not every customer will want to continue on with SolarCity after the initial lease term, but many will be happy to do so, and purchase additional products or services. These customers are clearly one of the reason's that Elon Musk and Telsa (NASDAQ:TSLA) want to purchase SolarCity.

Disclosure: I am/we are long SCTY.

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.