SolarCity (NASDAQ:SCTY) has been one of the more complicated companies to analyze for investors. The assumptions that went into the business model were that:
- Tax equity will continue to flow unimpeded due to the ITC extension.
- Debt will continue to be cheap.
- The Company can generate solid future earnings estimated at $3.87 per watt using the ABS model and $3.77 per watt using the equity sales model per the most recent investor presentation.
- The Company is a leader at deploying systems cost effectively at a market-leading $2.71 per watt as of the most recent quarter, and continuing to drive the costs down.
We have written about how many of these assumptions are completely invalid. When it comes to monetizing ITC, we see headwinds developing in the tax equity market (see Residential Solar Tax Equity - Winter Is Coming).
Cheap capital is also becoming scarce for residential installers. With the cost of ABSs and other forms of debt exceeding the discount rate assumed by the Company, raising additional debt, especially through ABS, is now questionable.
When it comes to monetizing the assets, we are skeptical that there is much value there to be monetized. This particular aspect was covered in the earlier article Equity Sales: Can This Financial Engineering Save SolarCity?
When it comes to the performance of the assets, there are three key areas of concern: we believe SolarCity overestimates the asset operating performance, underestimates O&M costs, overestimates asset term, and underestimates the cost of asset decommissioning. As we discuss in the article "Residential Solar Lease/PPA Industry Is Overestimating Rooftop Asset Value," the value generation of solar installations is overstated and the SolarCity guided numbers need to be adjusted downwards.
In this article, we review the John Hancock deal the Company announced yesterday and what it means in terms of value generation. We also look at the cost side of the equation and net the costs out against value generation and show that there is no NET value generation at SolarCity.
What Does John Hancock Mean To Value Generation?
While SolarCity's press release is sparse in terms of the exact dynamics of the deal, here is what we know:
- SolarCity monetizes the majority of its 20 years of underlying cash flows - including solar renewable energy credits (SRECs) associated with the projects - and retains ownership of the assets and continues to service the customers.
- SCTY retains a minority share of annual cash flows throughout the contract term as well as 99% of post-contract cash flows.
- The transaction raised $3.00 of financing per watt of solar generation capacity for SolarCity including tax equity investments, upfront rebates and prepayments; a blend of $3.24/watt for residential projects and $2.35/watt for commercial projects.
- The average FICO score of the residential customers in the portfolio is 744, and the commercial customers include a number of national brand retail locations.
- The projects were spread among 18 states with no single state representing more than 35% of the portfolio, and the vast majority of the installations were completed in 2015.
Why is SolarCity so opaque about what percentage of the 20-year flows it is monetizing? What does this "equity sale" mean to investors?
While one can hope otherwise, opaqueness is rarely a good sign for stockholders. This is even more applicable to SolarCity's shareholders as the Company has been demonstrating poor trends in terms of cost of capital.
Since SolarCity made the effort to monetize the cash flows, it appears unlikely that the Company intentionally did not sell a part of the cash flows. What is likely is that John Hancock left SolarCity with the O&M burden as well as the cash flows corresponding to O&M (including inverter replacement).
If we make such an assumption, this would also imply that SolarCity is responsible for all the residual risk including decommissioning of the asset at the end of life or on customer non-payment.
In effect, at $3 per watt, SolarCity has now completely monetized its revenue stream for the first 20 years of its asset life and is now left with uninstallation liability as well as some potential income during the renewal period.
What Exactly Is SolarCity's Cost Per Watt?
When it comes to costs, SCTY's position is that in the most recent quarter it cost the Company only $2.71 to install a system (see image below), but the value of the asset is $3.74. In other words, the Company is generating $1.03 in value per each installed watt. Voila!!
But, are SolarCity's assumptions and guidance valid?
Firstly, it should be noted that the assets SolarCity monetized with the equity sale are predominantly from 2015. If we use 2015 average cost as a proxy, the cost of assets on sale is likely to be on average about $2.85 per watt.
Secondly, the costs themselves are understated because the Company uses illusory bookings for a divisor for some calculations. We have routinely found that the bookings are overstated by about 30% (i.e. 30% of the stated bookings do not end up converting to installations in the subsequent periods). We suspect this is mainly due to customer cancellations after a contract is signed. Using effective backlog, the sales and marketing costs are likely to be higher by a dime or a nickel. The numbers will be much worse in disruptive quarter like Q1 2016 where a significant amount of backlog disappeared due to the adverse decision in Nevada. But even ignoring these recurring "one-time" events, a minimum of $0.05 per watt need to be tacked on to the costs. With this, we now have a cost of $2.95+ per watt.
Thirdly, SolarCity's cost computation methodology does not include the costs associated with stock-based compensation, M&A, or corporate interest expenses. While it is difficult to attribute the costs associated with these factors on a quarterly per watt basis, we expect the cumulative effect to contribute another $0.10 or more per watt in costs.
Adjusting for these costs, we can see that SolarCity's cost per watt of any assets it is likely to sell now will be in excess of $3.05 per watt. Note that even this $3.05 cost number is understated and the exact cost number could be higher depending on the time frame when the pool of assets was built as well as the corresponding corporate expenses during that time.
How Much NET Value Does SolarCity Generate Per Watt?
Having established that SolarCity's cost numbers are understated, we can now look at the value generation math.
Since SolarCity is selling the cash flows to third parties like John Hancock, it is possible that it has transferred the underperformance risk to these third parties. However, IF SolarCity has contractually guaranteed the performance of the assets as part of the equity sale, the Company may inherit significant additional downside risk that pushes the net value further into the red.
For the purposes of the net value calculation, we will optimistically assume that ALL the assets survive for 20 years, will perform as expected, and that there is a 50% uninstall rate after 20 years. With these assumptions, at $0.50 per watt for uninstall, the Value of each deployed watt declines to $2.75 per watt ($3.00 - $0.5*50%) with the type of equity sale done with John Hancock. Note that the net value of $2.75 is well below the $3.05+ cost of deploying the asset identified earlier in the article.
In essence, the stated SolarCity net value numbers are woefully short of what it takes to sustain the Company on an ongoing basis. Note that these value estimates do not incorporate any adjustments for degradation or O&M expenses in the linked article. Even with low-single-digit percentage adjustments for these factors, the value of each deployed watt drops even more precipitously.
This deal indicates that SolarCity captures a negative margin in excess of $0.05 ($3.00 announced value minus $3.05+ calculated cost) even after monetizing cash flows all the way to the 20-year point. The negative margin increases to $0.30+ if reasonable decommissioning costs are budgeted. These numbers are based on several favorable assumptions and actual numbers are likely to be worse. In other words, there is no value generation at the Company as far as investors can see.
The only way for the Company to continue its value-generation charade is to continue using the combination of unsupportable cost structure and showing the promise of future value generation with declining costs.
With the market for ABS closing and even the misguided short-term debt becoming increasingly expensive, and equity sales at reasonable discount rates unlikely, a follow-on stock offering may be the only option left for the Company to raise capital.
A properly-sized follow-on will reduce the risk in the Company's capital structure and give it a new lease on life. However, the window for the follow-on offering may not be a large one.
Given that the most fundamental assumptions behind the business model are no longer valid, it will be interesting to see how quickly the insiders will start lining up for exits. A follow-on offering is that is a combination of a primary and a secondary could be the tell here.
As the market catches on to the completely bogus set of cost and value-generation metrics, the music called capital inflows will stop. When the music stops, there will be no SolarCity.
Estimated value of the Company stock: $0
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Disclosure: I/we 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.