SolarCity: SPEs, VIEs and ADAs

| About: SolarCity Corp. (SCTY)

Summary

On November 17, 2016, SolarCity and Tesla shareholders are voting on their potential merger agreement.

Both companies have had high historical cash burn rates.

SolarCity has been utilizing all means necessary to conserve cash leading in to the merger.

Some of these methods have some significant implications on the future cash requirements for the combined company.

I recently wrote an article looking at Tesla Motors' (NASDAQ:TSLA) short-term cash flow requirements. I had opened a short position in Tesla via March 2017 Put options at $160 and wanted to reconfirm whether my thesis would have a decent chance to pay off. What this analysis lacked was a thorough review of Tesla's impending acquisition of SolarCity Corp. (NASDAQ:SCTY).

The companies have been heavily marketing the deal to both shareholder bases. During this period, Tesla posted record Q3 earnings (albeit with some heavy "kitchen sinking") as proof of concept that it has a viable financial future that can be applied to running the combined entity. The companies then held a joint conference call and presentation to tout the deal ahead of the November 17 shareholder votes.

Tesla's CEO Elon Musk is a major shareholder in both entities, but has recused himself from the vote. This helped the deal to gain support of proxy firm ISS by removing an obvious conflict of interest (though a competitor firm Glass-Lewis felt differently). I believe the deal is going through, so it will have a definite impact on my Tesla short position. This article attempts to see this potential impact, both immediately and longer term.

Recent Operations

For a thorough review of SolarCity's most recent Q3, I would recommend perusing this article, which admittedly has a bullish view to it. For my purposes, SolarCity posted a bottom line net loss (excluding NCI) of $225m in the quarter, comparable to prior periods, despite a significant boost in both revenue and gross margin. On a cash basis, it was a bit better with add backs for depreciation ($89.4m) and stock-based comp ($21.6m). SolarCity also was able to squeeze $87.9m out of its working capital by reducing inventory, stretching payables out, and releasing some restricted cash. With a few additional "mousenuts," SolarCity only went through $37m in cash flow from operations in Q3. SolarCity did continue to spend on solar energy systems, with $385m spent in the quarter. Overall, this is a hefty burn rate of $422m in the quarter, excluding cash flow from financing.

The Balance Sheet

The first item I went to was the amount of solar energy systems on the balance sheet. On June 30, 2016, the balance sat at $5.17b; this rose to $5.49b at September 30, an increase of $320m in the quarter, confirmed by the investment cash flow in the quarter.

Of greater interest was the substantial number of Variable Interest Entities (VIEs) that SolarCity has utilized:

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Source: SolarCity Q3 2016 10-Q

VIEs enable a company to securitize company assets against investments by investors in those assets. VIEs are used to raise cash without having to spin out the assets. They are a type of Special Purpose Entity (SPEs). The reason this term may sound familiar (for accountants anyways) is that they were predominantly used by Enron prior to its downfall in order to raise funds. The major difference is that Enron was allowed not to consolidate these entities into its financial statements, making them very opaque and disguising the source of Enron's cash flows. Enron's SPEs were pledged against its share price; once its share price began to drop, the entire circular funding began to unravel as these SPEs became insolvent, with recourse back to Enron. Due to rule changes brought in to prevent this abuse, SPEs, including VIEs, must be rolled in to the company books. To be clear, SolarCity is doing everything correctly in its treatment of its VIEs.

SolarCity has so far (to September 30, 2016) pledged $3.7b (67% of its value) of its solar assets to various investors in exchange for funding. This appears to have continued to escalate in the last few months, as SolarCity has continued to monetize its current and future solar assets in order to raise funds:

  • On September 12, it obtained $305m from an investment fund associated with George Soros from assets built in 2015 and 2016
  • On September 28, it obtained a total of $347m for future solar projects via Citibank
  • On October 17, it raised $300m for future solar projects via Credit Suisse

SolarCity is escalating the use of these securitizations going forward to try to minimize its cash burn on capex by financing it through its future cash flows. These VIEs (44 of them at September 30, 2016) are backed by the future cash inflows from its installed base of solar energy systems, with some implicit rate of return for the investors. The rates of returns are not disclosed anywhere I could find, although I will assume it is somewhere around 6%, based on how it's discounting the value of its assets in determining NPVs of its future cash flows.

SolarCity is essentially pulling cash forward from the future in order to fund its current operations. These operations are burning cash at roughly $400m a quarter. It also has $487m of debt coming due in the next year that will require refinancing (or repayment) as well. SolarCity can still monetize the remaining $1.8b of unpledged solar assets, but this will impair its future business model.

This also creates some substantial risks. First, with contracts this long, a lot can go wrong, from rising interest rates that make these VIEs less valuable to the holders, to the potential for default risk with an economic downturn in the economy. The VIEs are not bonds - they are more analogous to mortgage-backed securities with the same type of default and duration risks.

There may be some evidence that these risks are already beginning to manifest themselves when we look at SolarCity's accounts receivable:

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Source: SolarCity Q3 2016 10-Q

The curious trend is the growing amounts of the allowance for doubtful accounts. We can see this on a quarter-by-quarter basis, compared to sales and gross receivables:

Time Quarterly Sales Receivables (Gross) Allowance for Doubtful Accounts
December 31, 2015 $115.5m $38.3m $4.3m
March 31, 2016 $122.6m $45.8m $5.1m
June 30, 2016 $185.8m $71.7m $8.0m
September 30, 2016 $200.6m $77.3m $12.2m
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Source: Company Filings

With an increase in sales, it is expected that receivables will increase as well as the potential for bad debts. For SolarCity, with steady payments coming in, its receivables are roughly equal to one month of sales at any given time, which is to be expected based on its billing model. In the last couple of quarters, its Allowance for Doubtful Accounts (ADA) reserve has jumped significantly, even compared to the higher sales levels. It becomes a greater concern with the knowledge that the company is selling off its future revenue streams based on a steady stream of payments.

If this trend continues, the validity of its VIEs may come into question as SolarCity will need to come up with money to fund its obligations, even while continuing to lose money on its base business. It is possible that there is some default rate built in to the securitizations, but SolarCity will be on the hook for these payments out of its own coffers. This increase in ADA coincides with the launch of the solar loans, which now provides further funding support to its customers at 23% of booked sales (29% in September 2016) according to company's Q3 shareholder letter. These loans are not the responsibility of SolarCity, but of a financing partner.

This trend indicates to me that SolarCity is getting further and further down the line on the creditworthiness of its customers, which could impact its securitizations, much as it did in the Financial Crisis. At the same time, SolarCity is becoming more dependent on these transactions to keep the company afloat, with over $900m raised year to date.

I believe this focus on financing was a big driver in the changing of CFO from Tanguy Serra to Radford Small. Mr. Serra had a history as CEO of Vivint Solar (NYSE:VSLR) prior to his stint as president at SolarCity. Both of these were more operational type roles. Mr. Small has a strong history in financing as an investment banker at Goldman Sachs. This move also is likely in advance of the merger with Tesla. The combined company wouldn't need two CFOs, but the financing skill set brought by Mr. Small would be useful to continue monetizing SolarCity's assets in a post-merger entity.

The Takeaway

I believe that SolarCity is becoming more of a financing company than a solar company. It is gambling that its rate of return on its solar assets will exceed the imputed returns of its securitizations. It is unclear how much consideration of default risk has been built in though. With a rising allowance for doubtful accounts outpacing its sales, combined with a high take-up on its solar loan offering, this risk may be more real and impactful than initially considered.

SolarCity has been able to grow its sales and gross margin substantially. Unfortunately, the cash burn has grown, with SolarCity burning off $1.7b through the first 9 months of 2016 in operating and capital expenditures. The company has plugged this hole by borrowing from its future cash flows. I believe part of this is due to traditional debt markets becoming tighter. The most recent debt financing was almost solely subscribed by the Musk and Rive families.

The election of Donald Trump also could put some of the government funding that SolarCity receives at risk, though it is too early to tell how this would play out or how quickly.

I think the SolarCity acquisition has the potential to be a significant drain on Tesla, especially if it goes through more restructuring and cannot continue to grow sales. Tesla has some cash challenges of its own as I detailed here. I don't see SolarCity giving any relief, should its merger with Tesla go through. It may continue to plug its holes with these securitizations, but the rise in doubtful accounts may only exacerbate the risks.

With my Puts open to March, I see an immediate risk of $0.4b cash burn to Tesla in its first quarter post merger, with some potential integration costs on top. However, if the ADAs continue to increase, this could begin to pressure its financing as well. First Solar's (NASDAQ:FSLR) disappointing news late on November 16 also portends poorly for the industry. I don't believe that the combined entity will be going bankrupt in the immediate future, despite this cash burn as there is still enough "dry powder" to keep going on. Combining all of the above with a clear negative sentiment in the stock, I am comfortable to let my Put ride here.

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Disclosure: I am/we are short TSLA.

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.

Additional disclosure: I am short TSLA through Put Options