This article is written largely as a result of investor feedback on our last missive SolarCity Earnings: Great Growth, Funny Math. There appears to be fundamental lack of comprehension on what the "funny math" is by investors, and we hope this article provides clarity on one of its elements.
To have a meaningful discussion on the funny math, one must start with the cost dynamics of solar energy solutions. One of the best sources of cost estimates for solar solutions is solar panel market leader, First Solar (NASDAQ:FSLR) (see our thesis here). As of end of last quarter, First Solar had a system cost per watt below $1.50 for large-scale solar installations. While system cost is a key aspect of solar installations, the delivered cost of energy to a customer depends on the geography, tax incentives, and financing costs. Based on these factors, the Levelized Cost of Energy (LCoE) in large-scale solar farms is currently in the range of $0.05 to $0.07 per KWH. Note that these numbers are not for residential customers, but are indicative of the wholesale energy cost to utilities.
Residential solar installations are significantly more expensive on a cost per watt, or LCoE basis, due to their smaller size (kilowatt instead of megawatt) and the high labor cost of installing solar systems on customers' rooftops. The cost of energy from a newly purchased residential solar system today, depending on the region, is typically around $0.09 to $0.12 per KWH. Even though this LCoE is about twice that of wholesale costs, it is attractive from a retail customer's point of view. An added bonus is that once the system is paid off, the customer has a free energy source for many years to come.
The solar story is a great one now, and is getting better with every passing year. The current forecast from First Solar indicates that the system costs for utility farms will drop to about $1.00 per watt by 2017. The cost trend is likely to continue for the foreseeable future, due to improvement in solar cell efficiencies and reductions in other components of the system costs. Though the forecasts on future pricing will differ, the utility system cost per watt will likely drop below $0.50 per watt in the next decade. This system cost would indicate a wholesale cost level around $0.2 to $0.03 per KWH. Residential system costs will also drop substantially over this time period, but not to the same level as utility system costs. Whiles opinions on the subject can vary, a reasonable estimate of residential cost is approximately $0.05 to $0.06 (i.e. roughly twice the wholesale level).
Given these industry dynamics, we find long-term contracts of SolarCity (SCTY) (see our thesis here and here) bewildering. The company states that its PPA contracts are currently priced on average at about $0.15 per KWH. And the contracts are written with an escalator, where the energy rates go up a fixed percent every year. The escalator can vary with contract, and the cost of energy for customers will be different depending on the escalator built into the contract. The most often quoted SolarCity escalator is 2.9%, but we are not entirely sure if that escalator is representative of the portfolio of SolarCity PPAs/leases. If we assume an escalator of 2%, SolarCity lease/PPA customers would be paying approximately $0.22 per KWH twenty years from now when their leases expire. A 3% escalator would imply a rate of approximately $0.27 per KWH twenty years from now.
In other words, SolarCity's business model is based on selling uninformed customers a system with rising electricity prices, when costs of solar energy will be coming down dramatically over the contract period. And, while SolarCity is the pioneer of this model, it is not the only company that is relying on this model. Other companies following the same model include: SunPower (NASDAQ:SPWR) (see our thesis here) RGS Energy (NASDAQ:RGSE) (see our thesis here), and more recently, SunEdison (SUNE) (see our thesis here).
There is widespread agreement in the industry that it is more cost-effective for a customer to buy a solar system than do a lease/PPA. So, why would people pick a PPA/lease? Especially the leases with increasing energy costs? How are SolarCity and the other industry players selling their leases to customers? We believe the answer to these questions will lead one to the invariable conclusion that there is a certain amount of misinformation, snake oil salesmanship, and customer greed that are causing these instruments to pervade.
The following are the likely profiles of residential lease/PPA customers who are signing up for these leases:
- Short-term owners: People evaluating purchase of solar system typically see a 5 to 9-year payback period on buying a solar system. Some customers decide that they will not be owning the property long enough to get a payback. This segment is a rational segment in the sense that they have made a choice based on known facts and have decided to take the lease/PPA path. But there is another way to look at this: This customer is expecting that there is no cost to him for the solar installation and he gets the benefits of lower energy prices as long as he lives in the house - in other words "free money". A savvy customer should realize that if something is too good to be true, then it probably is not true.
What happens when a customer with as lease/PPA decides to sell the house? The new buyer, depending on how informed he/she is, will:
- Accept the lease/PPA assignment, because they do not know any better or do not care.
- Not accept the assignment, because they know that because of the falling solar prices, they can buy a superior and much more cost-effective system at a lower cost. Or even if they do not want to buy, they can get much cheaper lease/PPA from the market than the old system on the roof. These buyers will either ask the owners to clear out the lease/PPA or ask for a discount, because the system on the rooftop is not cost-effective (some buyers may not like the look of the system on the rooftop, but that is a different topic).
Both of these choices will cost the seller much more than whatever little he/she may have gained by going in to the lease/PPA in the first place. This is the scenario that is likely to play out increasingly as the market awareness increases. The result is that the default rates are going to increase and the leases/PPAs are going to get a bad name. This customer, in the long term, is too smart for his own good, because he bought into a "something for nothing" deal.
- Misinformed owners: These are customers who made a poor choice based on bad information, or those prone to making poor financial choices.
- These customers will be blissful until they start realizing that they made a bad choice. Similar to the scenario earlier, as the market awareness increases, the default rates are going to increase and the leases/PPAs are going to get a bad name. One also has to wonder about the long-term credit risk of a customer with this profile.
- "Green" customers: Customers who want to do things that are "green" and are not really looking at the economic side of things. If the green customer has the money, then they buy green. If they don't have the money, then they sign a lease/PPA. This is likely less than 10% of the customer base. These customers may not care for the economics, and may remain good lease PPA/customers at least through the lease period. The only time a deal with this customer is likely to go bad is when their perceived value of being green drops below the pain threshold of making a poor financial choice.
So much for the customer side of the story.
From the investor perspective, SolarCity asserts that these leases will not only have low default rates, but after 20 years, they will be able to renew the leases at 90% of the exorbitant prices seen above. That would mean customers would spurn the potential retail solar energy rate of $0.05 to $0.06 per KWH and opt for SolarCity's $0.20 to $0.24 per KWH (90% of $0.22 or $0.27, depending on the escalator %). Regardless of what the customer profile is, we believe that no sane customer is likely to renew the existing PPAs/leases at 90% of the going rate, as SolarCity management claims. The optimistic case for SolarCity management is renewal at a rate that is about 30% initial contract value (i.e. around $0.05 to $0.06 per KWH).
Even that may be doubtful. A savvy customer could actually ask SolarCity to pay money to keep the system on the house when the lease expires. It would be cheaper for SolarCity to pay off the customer and leave the system on the roof than incur the expense of removing and transporting what is likely to be a highly inefficient system with very little market value. In other words, the retained value at the end of 20 years could actually turn negative.
Investors who buy a company's story without doing due diligence on the company's retained value shenanigans are in for a rude surprise.
If and when SolarCity makes a more rational set of assumptions in its retained value, the company's financial results will not look pretty, but as a public company, its management needs to make a better set of assumptions for its business plan and share them with the stockholders.
The company also needs to better educate its customers before having them sign these unattractive long-term contracts. One would think that social responsibility is an attribute that a "green" company would strive for.
Disclosure: I am long FSLR. 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.