Will The Sun Eventually Set On SolarCity?

About: Tesla, Inc. (TSLA)
by: Bennington Investment Ideas

SolarCity Corp. (SCTY) has been a Wall Street darling as it has led the solar sector higher. Based on a recent closing price of $41.67 per share, SCTY is up 238% year to date. In comparison, the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) is up a measly 17%, including dividends, over the same time period.

SCTY is a fully integrated provider of distributed solar photovoltaic solutions to residential and commercial customers. SCTY participates in all parts of the downstream value chain (not to be confused with the upstream value chain which focuses on module manufacturing) ranging from Marketing & Sales to Financing to Design & Installation to Asset Management and Customer Service. This integrated approach allows them to potentially capture all the available profits in the value chain; however, the only problem is that this profit does not exist. SCTY is losing money (negative net income) and will continue to lose money based on analyst projections into 2014 with a slightly smaller loss of $1.28 EPS when compared to a 2013 loss. Based on these trends, one could see losses in 2015 and perhaps beyond.

SCTY Captures Value that Homeowners Cannot

SCTY's value proposition largely rests with the legislated subsidies that homeowners cannot easily monetize and others that homeowners simply cannot capture. However, almost all of these benefits are scheduled to expire or diminish in the near future.

  1. Federal Investment Tax Credit "ITC" - the Federal ITC represents the 30% Tax Credit that homeowners can receive based on the installation of a solar PV system. The 1603 Treasury Cash Grant program used to allow for easy monetization of this subsidy; however, that expired at the end of 2012. Now one needs tax equity to capture the full benefits immediately. Tax equity is from an entity with an immediate tax liability that can be offset with the credit. However, the ITC amount of 30% is set to drop to 10% with the start of calendar year 2017. While homeowners can capture these benefits on their tax filings, it is much easier to let someone else do the work for them.
  2. Bonus Depreciation - Bonus depreciation was another benefit for the industry that was completely unavailable to homeowners. In the first year, a business could take a 50% of the cost basis of the solar PV facility as a depreciation expense. The remaining 50% was then depreciated using a more traditional 5 year MACRS (Modified Accelerated Cost Recovery System). In the absence of new legislation, bonus depreciation will expire at the end of 2013.
  3. MACRS Depreciation - Solar PV systems have very long lives. With regular maintenance and periodic inverter replacement, they can last up 25 years. Some companies even expect their useful life to be up to and past 30 years. However, for tax purposes, Solar PV is eligible for a 5 year MACRS, which means that their costs are depreciated over a much shorter frame - again creating a financial benefit. As homeowners cannot normally capture depreciation expense, this is another way firms like SCTY can add value.
  4. Cost Basis Adjustment - Given the Federal ITC that reduces the cost of installing a solar PV system, one might think that the depreciable cost basis (used for calculating depreciation expense) would be reduced by a similar amount. Well not quite, solar PV is receiving special treatment. One can still use 50% of the Federal ITC in the cost basis. This essentially means that you can double count 15% (50% x 30%) of the cost a solar PV system when figuring taxes. The first time is as the Federal ITC and second time is through depreciation expense. Again, homeowners who cannot use depreciation miss this benefit.

However, most of these subsidies are scheduled to expire or could even be subject to legislative change. Given the declining price of solar and the current make up of Congress, it seems unlikely that these subsidies will be extended or expanded. As they disappear, homeowners would no longer need to monetize them through companies like SCTY.

Declining Solar PV Prices Will Eventually Eliminate the need for Specialized Financing

Customers also need firms like SCTY is to finance solar PV systems due to their high cost. A typical residential solar PV system size can range from 3 kWp up to 6 kWp. Depending on where you live, this can produce between 4.5 MWh and 9 MWh per year which represents a good portion of a homeowner's annual electricity consumption. According to SEIA, residential solar PV systems prices dropped 15.8% in Q1 2013 from a year ago. The prices have now dipped below the $5.00 per Wp level to just $4.93 per Wp. These price drops have been pretty consistent for the past several years and are expected to continue. However, even at $4.93 per Wp, the system would cost almost $30,000. One needs more financing help to install a solar PV system that costs almost $30,000. However, as these prices drop and can approach $2.00 per Wp or even low, homeowners may no longer need significant financing help. A small solar PV system that costs $6,000 or less might well be within reach of many individuals. (You can think of this as a bond like investment with inflation protection since you'll be saving on the price of electricity for a very long time.) This creates the second challenge to SCTY's long term business model. Furthermore, solar PV systems will likely be included in new homes, much like water heaters and HVAC systems resulting in financing through traditional mortgages.

SCTY Must Adapt Its Service Offering

These trends have not gone unnoticed by SCTY. They are rapidly seeking ways to adapt their business model to remain relevant. A key observation is that homeowners will still most likely still need someone to perform maintenance on their system. Climbing around on a rooftop to fiddle with electric equipment is not a good hobby for the overwhelming majority of homeowners. A second observation is that SCTY can still provide "for cash" installations of solar PV systems.

However, the more interesting solution is SCTY's expansion into energy storage. This adds some additional complexity to the technology, but also raises the overall cost back up to a level where financing is required. Lithium batteries are still very expensive, even if you are using Tesla Motor's (NASDAQ:TSLA) batteries. This type of solution would provide homeowners even more flexibility and perhaps even the possibility of completely eliminating that electric bill, much to the fear of many utilities. However, with just 65 reservations for solar and storage solutions in California, these concerns are still in the future. But not that far, since SCTY has announced plans for a larger commercial rollout by 2015.

Bottom Line

Solar only solutions will not be able to drive profitable growth at SCTY over the long term. However, if SCTY can continue to drive its business model towards micro-grids and other advanced energy solutions, it can leverage the declining cost of distributed generation to pose a significant challenge to the existing utility business model. This could ultimately be very profitable, much to chagrin of existing utilities.

Disclosure: I am long SPY. 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: Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.