Today, we have published our research on SolarCity (NASDAQ:SCTY). Despite declining since our first blog entry, it is our opinion that SolarCity's stock has at least 69% downside from current levels. Please read our DISCLAIMER at the end of this synopsis. For the full PDF report (30 pages), please go to the following link:
As the bull market enters its fifth year, it is completely rational to expect institutional investors, accompanied by the return of retail, to do completely irrational things. Basic fundamental analysis has been trumped by simply identifying stories and/or derivative "plays" on a hot theme. There is no better example of this than the lunacy that has engulfed SolarCity (SCTY). Its perceived affiliation with Tesla (NASDAQ:TSLA) and Elon Musk, combined with renewed excitement for residential solar, has created one of the more misunderstood and risky stocks in recent memory.
Before discussing SolarCity, it is imperative to separate Elon Musk and Tesla from SolarCity. We are not short Tesla. In fact, we marvel at Tesla's success in the face of so many skeptics and obstacles. We believe there is a chance Tesla will indeed become the next great American auto company, led by the brilliant visionary Elon Musk. Tesla has real intellectual property, a brand that is arguably becoming the standard in the high-end EV market, real manufacturing, and is potentially on the precipice of driving sustainable economic profits for its shareholders. That is Tesla.
SolarCity on the other hand looks nothing like Tesla. The commonality between SolarCity and Tesla is quite simple: Both companies have been heavily reliant on government subsidies and the largest shareholder of each is Elon Musk. The similarities end there.
Elon Musk is the Chairman of SolarCity and has provided financial support for SolarCity all of the way through its IPO. However, SolarCity is not run by Musk, but instead by his cousins, the Rive brothers - Lyndon (NYSE:CEO) and Peter (NYSE:COO). There is nothing wrong with a family affair, but shareholders that believe Musk is somehow involved in SolarCity's day-to-day operations are sorely mistaken. Musk recently went so far as to emphasize distance from SolarCity, stating at D11, "He doesn't want credit for SolarCity."[i] Ironically, it was his perceived involvement that began the SolarCity advance on the heels of Tesla's success. Despite its own disappointing Q1'13 earnings report, which led to two downgrades, SolarCity's shares have risen by 100% since Tesla reported its Q1'13 earnings on May 8th.
Based on a future value story, and the perceived Elon Musk tailwind, investors currently value SolarCity at more than 500% of management's black box Net Present Value. As we discuss at length in our report, we believe SolarCity's business does not at all resemble the story that the day traders and retail investors believe. We show pervasively aggressive accounting and non-GAAP, black box contrived metrics that should remind any experienced investor of metrics like "eyeballs." SolarCity has many other problems besides simply attaining an egregious valuation through a fanciful story. In our opinion, SolarCity has also misrepresented its financial profile, changing key assumptions underlying net present value (NYSE:NPV) without explicitly disclosing these changes to investors. The NPV uses a preposterous discount rate of only 6%, while management has also insincerely tried to convince investors that their immature credit is on par with mortgage and utility credits (a utility turns off your electricity if you don't pay… how does SolarCity centrally turn off your electricity without a truck roll and how do they repo a system cost effectively?). Additionally, we will analyze third party data that seems to unequivocally conclude that SolarCity has been fleecing tax payers by overstating the fair market value (NYSE:FMV) of systems that are used to determine 1603 Treasury grants. We are not calling SolarCity's business model a Ponzi Scheme built on tax payers, but we do believe that the current IRS audits and Treasury Inspector General subpoenas could create a significant risk for SolarCity's reputation, financials (with undisclosed, off-balance sheet potential liabilities), and shareholders. In an extreme case, we believe SolarCity's own S1 liability example, could imply an off-balance sheet, undisclosed liability of as much as $153 million (this would be a 45% FMV overstatement which is not our base case). There are of course other flags such as selective disclosure, SEC financial filings that do not reconcile with press releases and investor presentations, and public statements that we believe are materially incorrect.
This is a lengthy report, and many investors simply will not get through it all. We would encourage any investor or interested party in the SolarCity story to focus on the Sections below with "**" next to the number, spending extra time on Sections 3, 6, 9, 10, 11. For those that are time constrained, or have short attention spans, starting on Section 3 would be prudent.
We expect a passionate defense by certain sellside analysts, especially considering some of the "let's prep for a deal" type arguments made in some recent notes. For example, CSFB recently upgraded the stock, raising its price target to $52 per share, just one month after carefully establishing a $28 price target. To justify this ho-hum change of 86%, or approximately $2 billion in market capitalization, the analyst stated after "discussions with the California Public Utilities Commission (CPUC)… we are more comfortable that the CPUC and California governor will continue to support distributed solar generation even if the net metering cap is not raised by 2015." This is not new. Further, it would appear he had some disappointing inside information (our words, not his) that actually seems incrementally negative, "SCTY conversations with rating agencies for asset-backed securities are progressing, albeit at a slightly slower rate than anticipated." Our point is simply to illustrate how some analysts have become rather subjective in their interpretation of data points, and we are hopeful they will digest our non-conforming analysis before cavalierly rejecting it.
If nothing else, we would expect our report to force SolarCity to provide much improved disclosures. Aaron Chew, who recently joined SolarCity as VP of IR, has tried to improve the black box disclosures. However, it is a bit challenging to be anything but skeptical considering he had a $16.50 price target on SCTY as a sellside analyst just three months ago, while arguing for a HIGHER discount rate than the black box generated 6% the company uses (His research was actually quite thoughtful).
The bottom line is investors have been hypnotically drawn to SolarCity, like moths to a flame, dangerously ignoring the house of cards on which the story appears to be built. As one industry publication wrote, "Given SolarCity's previously reported-upon GAAP, Treasury, Internal Revenue, Franchise Tax Board and other state taxing authority issues, at best aggressive treatment and at worst fraud concerning stepping up the tax basis of their installed systems to claim ITC"[ii] this may be a story for investors to simply avoid.
1) The Business: Hyper-Competitive with No Barriers: Despite commanding a biotechnology multiple, SolarCity appears to be nothing more than a hybrid of a specialty finance company and an engineering & construction company. The business model is almost entirely dependent on tax payer subsidies and there are minimal barriers to entry. There is minimal intellectual property and intense competition for customer leads. SolarCity is just one of dozens of residential solar installation companies that will be disintermediated over time.
2) Pulling Out All of The Stops To Get Public?: SolarCity had to price its IPO at $8.00, 43% below the middle of its original range. The story was so uninspiring just six months ago that Elon Musk and other insiders had to absorb nearly 25% of the offering to get SolarCity a public currency. Elon Musk margined 6 million SolarCity shares against a loan from Goldman Sachs, who is also the lead underwriter on Tesla, and a tax equity partner of SolarCity. In addition to pledging some of his SolarCity shares, the Chairman has also borrowed at least $150 million from Goldman Sachs. To boot, SolarCity and Goldman combined to issue a promotional press release just weeks before the lock-up that announced a financing deal that had previously been established and partially drawn.
**3) The NPV Black Box Sausage Factory: SolarCity utilized a black box calculation for retained value that discloses very few of the underlying assumptions. When it was trying to complete its IPO, SolarCity used a 10-year renewal assumption of 80% of the year 20 contract value (for years 21-30). However, after its IPO, SolarCity appears to have changed the fine print of this assumption to 90% renewal which has materially inflated NPV. Further, in its pre-IPO presentation, SolarCity claimed 1/3 of the NPV ($5,000) per customer came from renewal. However, in its Q1'13 presentation, 46% of the NPV is associated with renewals, suggesting their underlying NPV assumptions have been materially altered. SolarCity uses a preposterous 6% discount rate for its NPV, a figure we show is not only aggressive, but seems to ignore a myriad of unaccounted-for risks. SolarCity is also subject to extreme interest rate risk, which only magnifies the refusal to change the discount rate by at least the 52 basis point rise in the 10-year yield since its IPO. SolarCity also assumes in the fine print of its NPV that is can increase prices by 3% per customer, per year, for 29 straight years. Finally we show the extreme NPV sensitivity to small changes in these assumptions. For example, if SolarCity can only raise prices by 2% per year for 29 years, and uses a more appropriate discount rate that simply accounts for the rise in the 10-year, then their internal calculation of retained value would be 22% lower. If SolarCity is unable to raise prices in the future, should interest rates rise, or net metering policies become less favorable, we believe SolarCity's business may not be solvent after the ITC expires on December 31, 2016.
**4) A Business Model Dependent on Tax Credits and Subsidies: SolarCity's economic model is currently reliant on the investment tax credit, bonus depreciations, and MACRS depreciation. Even with these goodies, we believe the majority of the economics in its model accrue to its JV partners (like Goldman Sachs who will likely have many more financing announcements given the economic tax payer pillaging). We calculate an approximate year 1 return to SolarCity's partners of at least 47.85% on a solar investment, almost none of which accrues to SolarCity shareholders. We show that depreciation and tax attributes represent 100% of SolarCity's purported retained value, which does not even begin accruing to shareholders until after year 5 under flip accounting. Almost 75% of SolarCity's most recent quarter's solar installations were funded by Treasury grant receipts. WE WOULD ASK THE COMPANY TO DISCLOSE IF ANY OF ITS EMPLOYEES OR RELATED PARTIES ARE DIRECTLY INVESTED IN TAX EQUITY FUND PARTNERSHIPS THAT PLACE INSIDE INTERESTS IN A SUPERIOR AND ACCELERATED POSITION TO SHAREHOLDERS. WE HAVE NOT SEEN THIS DISCLOSURE IF INSIDERS HAVE INVESTED IN ANY OF THE JOINT VENTURE FUNDS, WHICH WOULD CREATE MASSIVE CONFLICTS.
5) The Inspector General and IRS Come-A-Asking: SolarCity has been subpoenaed by the U.S. Treasury Inspector General and at least two of its joint venture funds are being audited by the IRS for potentially overstating the fair market value (FMV) of its solar systems. Investors and sellside analysts appear to be completely unaware of the undisclosed liabilities that SolarCity would face should it be found guilty of fraudulently overstating FMV to obtain higher ITC values. Based on public disclosures and our understanding of the pre-defined fund return guarantees, SolarCity would be liable for any claw backs or shortfalls in ITC pay-outs relative to fund-level expectations. The Wall Street Journal recently reported that SolarCity has in turn sued U.S. tax payers (indirectly of course) demanding more stimulus money/tax credits than they have already received. SolarCity is actually suing AFTER already receiving close to $400 million in tax payer subsidies, grants, and tax credits. These lawsuits are just one more reason why SolarCity's 6% discount rate is so absurd.
**6) Does the Evidence Suggest SolarCity Has Been Ripping-Off Tax Payers?: We present data sets from a fantastic public analysis that irrefutably suggests SolarCity was submitting materially higher FMV for leased systems. SolarCity, and its partners (like Goldman Sachs), retained the overstated tax payer subsidies and credits on leased systems. The Institute for Self-Reliance has asserted that "in the case of SolarCity's California operation, in particular, reported prices [were] often much higher for leased payments than for customer-owned solar arrays."[iii] Run On Sun Founder and CEO Jim Jenal's study should be mandatory reading for all SolarCity investors and analysts. His datasets, combined with public records from California's Solar Initiative Organization, shows SolarCity had been unequivocally reporting a higher FMV for systems to be leased. We present tables analyzing more than four years of data that clearly shows SolarCity has been claiming an FMV as much as 45% more for systems to be leased compared to those that were sold. SolarCity competitor Verengo, had actually submitted costs for solar systems to be leased that were a 6.4% discount to those that were sold. Just two months before SolarCity's IPO filing, its costs magically started to come down, after flat-lining for 13 straight months. At almost the exact time costs began to decline, Elon Musk conceded in a Bloomberg interview "There is this question of how do you account for something when it's a lease? Not all of them are structured in the same way. We want to just double-check with our auditors and the SEC before we file to make sure the accounting is correct."[iv] We present a Correspondence letter from the SEC that also suggests they questioned SolarCity's accounting AND leads us to wonder if SolarCity had initially attempted to recognize rebates as revenue. Despite all of these business risks, the sellside and the company continue to use a 6% discount rate.
**7) The Off-Balance Sheet Liabilities and Implications: Based on SolarCity's own filings, they admit that in some instances, the U.S. Treasury has already determined "a materially lower value than we had established in our appraisals."[v] Should previously recognized Investment Tax Credits be repealed or awarded at lower rates, we believe SolarCity will be forced to "true-up" these funds with cash injections OR allocations of future system installs. Based on our inability to find comprehensive disclosures by JV fund, we believe SolarCity directly ignored an earlier SEC request for increased transparency on fund economics. Within the last six months the U.S. Treasury has notified a SolarCity investment fund that it was reducing its rates for California and Arizona, causing SolarCity to confess, "as a result of this updated guidance, we will be obligated to contribute additional solar energy systems to this investment fund so that the fund investors will recover a shortfall."[vi] It seems SolarCity shareholders are junior to at least some fund investor economics.
8) You Get What You Pay For and Politics Is No Exception: SolarCity has applied for almost $400 million in stimulus grants. According to the Center for Responsive Politics, SolarCity spent at least $535,000 in 2009 and 2010 to lobby Congress and the DOE on a variety of provisions and legislation. SolarCity was successful in getting the ITC (Section 1603) extended and is now subject to accusations that it "repeatedly overstated the value of its investments" and by extension, has cost tax payers millions of dollars. SolarCity's Chairman, Elon Musk, gave more than $100,000 to Obama's re-election campaign, $290,000 to political candidates and the major parties from 2008 through 2012, which included $66,200 to the Democratic National Committee, $34,400 to the Democratic Senatorial Campaign Committee, and $63,500 to the National Republican Congressional Committee. Tesla Motors spent $480,000 from 2007 to 2011 to lobby Congress, the White House, EPA and DOE on climate and energy issues, the Advanced Technology Vehicles Manufacturing loan program, the Promoting Electric Vehicles Act, and the Recovery Act.[vii] Tesla received a $465 million loan from Obama's DOE while SpaceX received at least $824 million from NASA through a special program known as the Space Act Agreements, which circumvents much of the oversight in other federal spending.[viii] The magnitude of SolarCity's (and its affiliates) lobbying efforts may only serve to amplify the scrutiny as its FMV calculations are put under the microscope.
**9) Short Public History; Long List of Financial Inaccuracies and Misstatements: We detail even more examples supporting our belief that SolarCity is playing loose and fast with its numbers while using very aggressive accounting. SolarCity's CFO was the CFO at Calpine from March 2002 through November 2005. Calpine filed for bankruptcy weeks after he resigned, and only weeks after his finance team made "a simple error" that overstated another non-GAAP measure, EBITDA, to analysts and investors by a ho-hum $136.8 million, or 26%.[ix] A Green Tech Media article, covering the SCTY IPO, went so far as to cite a "source close to the company [who] suggested that when it came to the SEC paperwork, [SolarCity] had an 'aggressive' CFO." SolarCity uses a 30-year depreciation schedule on its equipment despite customer contracts that are only 20 years. An earlier SEC registration statement filed confidentially under the JOBS Act alludes to contracts as short as 10 years. We show SolarCity's estimated nominal contracted payments for Q4'12 were changed between its 10K and Q1'13, reflecting a $17.8 million difference. SolarCity's CEO made what we believe was a materially false and misleading statement on its Q1'13 earnings call that may have led investors to believe every customer remains so for at least 30 years. SolarCity also announced it will no longer be providing a backlog metric, because they "don't like it" despite listing backlog (specifically megawatts shipped and deployed) as "key metrics" just six months earlier in its S1. SolarCity guided Q2'13 significantly below consensus, leading us to wonder why management has been so incapable of aligning bullish sellside models with the mechanics of the business.
**10) Last But Not Least, the Model May Already Be Fraying: SolarCity's disclosures obfuscate the net interest margin (NYSE:NIM) making any reasonable analysis of the existing portfolio yield almost impossible. However, our analysis suggests SolarCity's incremental solar system investments in Q1'13 are expected to yield a NEGATIVE 18.1% return on invested capital. SolarCity spent $138 million on capex for new solar energy systems in Q1'13. BASED ON SOLARCITY'S OWN DISCLOSURES IN ITS DEFINITIONS APPENDIX, IT APPEARS THAT THEY WILL ONLY GENERATE AN INCREMENTAL $113 MILLION OF FUTURE CASH FLOW ON THE ADDITIONAL $138 MILLION OF SOLAR INVESTMENTS. This $25 million dollar shortfall can not be explained by system depreciation and amortization, which was only $7.4 million in Q1'13, nor can it be explained by matching nuances because the systems and estimated nominal payments both include those leased and to be leased. We believe this analysis could poke a gaping hole in SolarCity's entire story and may be the reason they refuse to disclose asset yields and direct financing costs. New customer growth also collapsed, declining 17% year-over-year in Q1'13. Finally, the Net Solar Energy System change on the balance sheet does not reconcile with the change in the cash flow statement, while a 30-year depreciation schedule applied to starting system asset values would have resulted in more depreciation that SolarCity inexplicably reported for D&A combined.
**11) Fair Value - $11.38 - Throw a Dart: We believe valuing SolarCity on fundamentals is virtually impossible. There are minimal sales (63% of 2012 sales were not leases, but one-time hardware sales at a 23% gross margin), negative EBITDA and free cash flow is misrepresented because their definition adds back cash from financing. Based on SolarCity's own disclosures, which we have argued are completely illusory, the net present value of future cash flows is worth approximately $6.69 per share. Of the $569 million of NPV, we would point out that 46% is derived from "renewals" in years 21 - 30, presumably at the egregious renewal assumption of 90% of contract value. At $37.00 per share, this implies $30.31 of value, or $2.58 billion of present value that needs to be created in the future. To simply justify today's current price, SolarCity would need to reach $2.576 billion in present value terms? Generously applying ZERO discount rate, this would still require installs of 2,061 MW (2.06 GW) in the next 5 years, or 24% more MW installed each year than SolarCity has done cumulatively since inception and 65% more than the installation guidance for 2013. Installing 2.06 GW would equal approximately 355,358 households (519% more than they have installed since inception) using their historical installed watt/household, while requiring $9.37 billion of capital to just hit the implied installed watts. These heroic assumptions are needed to simply justify anything close to the current stock price. This analysis also generously assumes no impact from the ITC being reduced from 30% to 10% on December 31, 2016. While stocks rarely trade in a straight line to fair value, we believe fair value is around 2x theoretical NPV book value, or a 100% premium to the company's calculation of present value per share using their absurdly low 6% discount rate. This would equate to $11.38, which would represent 69% downside, but still be 42% above its IPO price.
IMPORTANT Disclaimer - Please read this Disclaimer in its entirety before continuing to read our research opinion. You should do your own research and due diligence before making any investment decision with respect to securities covered herein. We strive to present information accurately and cite the sources and analysis that help form our opinion. As of the date this opinion is posted, the author of this report has a short position in the company covered herein and stands to realize gains in the event that the price of the stock declines. The author does not provide any advanced warning of future reports to others. Following publication of this report, the author may transact in the securities of the company, and may be long, short, or neutral at any time hereafter regardless of our initial opinion. To the best of our ability and belief, all information contained herein is accurate and reliable, and has been obtained from public sources we believe to be accurate and reliable. However, such information is presented "as is," without warranty of any kind - whether express or implied. The author of this report makes no representations, express or implied, as to the timeliness or completeness of any such information or with regard to the results to be obtained from its use. All expressions of opinion are subject to change without notice and the author does not undertake to update or supplement this report or any of the information contained herein. This is not an offer to buy any security, nor shall any security be offered or sold to any person, in any jurisdiction in which such offer would be unlawful under the securities laws of such jurisdiction.
Disclosure: I am short SCTY.