SolarCity Offers Compelling Risk/Reward Opportunity

| About: Tesla, Inc. (TSLA)
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SolarCity (SCTY) is one of those stocks that seems to defy reason and gravity. Shares of the company have been on a tear in 2013, starting the year just north of $12 a share and trading hands currently at ~$35. Shares were at one point north of $50 at the height of the Elon Musk euphoria trade. This is a quick and to the point opportunity-driven article for investors who believe in SolarCity. This investment would be designed to generate a maximum 10% return over the next four months, even if the stock were to fall by over 30% from its current levels. This is a fairly significant margin of error, if you will, and with the volatility seen in shares of the stock this year is probably necessary to placate fears that the stock could come crashing back down to earth.

However, with much of the event risk removed from the stock after a number of capital raises and guidance upgrades over the past few months, the overall risk profile of SolarCity has improved remarkably. Yet the market is still incorporating the volatility seen earlier in the year into its future outlook for SolarCity. And that has led to the ability for investors to profit from that volatility.

The Addressable Market for SolarCity Is Gigantic

There is a very simple reason why investors should feel confident that SolarCity has a bright (no pun intended) short-term outlook. The company is operating in an addressable market that is almost unquantifiable at this point. Putting the commercial market opportunity aside for a moment, consider just the opportunity in the new residential construction market in the U.S. At the end of Q1 2013, SolarCity reported having over 57,000 customers, which was an increase of more than 100% from the prior year. During the quarter, the company added 7,000 new customers. What is most important about the SolarCity story is that the company is becoming embedded in the new home market, partnering with the top homebuilders in the country. The company CEO had this to say on the Q1 2013 earnings call about the opportunity in the new home market:

We're excited about the new home builder market. Just for reference, the new home builder market and the market that we service install roughly 120,000 to 150,000 new homes a year. The entire solar industry does not install that amount of systems. So when you look at the size of our market, rooftop solar, it is massive. In fact the market is growing and becoming bigger every year at the current installation rate.

Think about that number for a moment. SolaryCity has a total of 57,000 customers currently. The new home market the company currently operates in generates 120,000-150,000 potential new customers on an annual basis. This is just the market the company currently operates in, from a geographical standpoint. Historically, new residential construction has added over one million new homes a year of the last three decades in the U.S.

New homebuilders provide the greatest opportunity for SolarCity to take solar power mainstream. The company can partner with builders, offer favorable pricing terms, and gain scalability from an operating cost standpoint by having increased penetration in markets and communities. Installing a solar panel on one house here and another house there is profitable, but not nearly at the level that would be seen from installing solar panels on an entire community of 500 homes.

Energy efficiency is one of the greatest differentiating factors that new homebuilders can offer over the existing home market. Homes built 50 years ago, or even 10 years ago, have nowhere near the energy efficiency profile of those homes being built today. As solar power becomes mainstream, that differential will tilt even more dramatically in favor of new homes. The homebuilders tout energy efficiency heavily, and SolarCity is aggressively moving to corner this market.

Investment Opportunity

It is pretty much a given in the stock market that companies that have safe financial profiles and operate in gigantic addressable markets will also be in demand, which provides a floor in the stock price. Consider Amazon (NASDAQ:AMZN), Salesforce (NYSE:CRM), and Workday (NYSE:WDAY) -- all trade for ridiculous valuations from a P/E standpoint. The market will bear these valuations because the future growth opportunity for each of these companies is gigantic. The same condition exists for SolarCity.

The investment opportunity I would suggest is to sell the October 2013 $24 put options for $2.40 in premium. This trade would result in investors earning a 10% return on their investment, as long as SolarCity is above $24 a share when the options expire in October 2013. Over that four-month time period, shares of SolarCity could fall by ~30%, and the investment would still generate at 10% return. Should the shares fall below $24 investors would be obligated to purchase the stock at $24, and would have an effective basis in the shares of $21.60 ($24 - $2.40 in premium = $21.60). This gives investors downside protection of ~40% from where SolarCity trades today before this investment would incur any losses at all.

This is an opportunity to generate a 10% return in four months, the equivalent of a 30% annualized return. Is SolarCity a volatile stock? Absolutely. But it is also that volatility that allows an investor to earn 10% on an investment where they can afford to see the stock fall 30%. The kicker is that if you end up owning shares of SolarCity, you own a company that has so much potential upside that it's hard to see a scenario in which the shares are not bid up again in the future.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.