Tesla's (NASDAQ:TSLA) announcement to purchase SolarCity (SCTY) has created significant discussion and debate.
This posting a) establishes baseline definitions of vertical integration, b) analyzes whether the Tesla/SolarCity combination creates vertical integration benefits, and c) provides high-level valuation methodologies for perceived vertical integration benefits. The posting draws exclusively from public documents and/or communications made by Tesla and SolarCity management regarding the vertical integration benefits of the acquisition.
Baseline Definitions of Vertical Integration
In the dialogue around the Tesla/SolarCity combination there has been considerable use of the term "vertical integration" as driving the strategic merits of the deal.
In his landmark book, Competitive Strategy, Michael Porter defines vertical integration as "the combination of technologically distinct production, distribution, selling, and/or other economic processes within the confines of a single firm." By vertically integrating, a firm seeks to create greater net value than if it were to obtain the same competencies through a marketplace transaction. Vertical integration is not intrinsically good in and of itself. Rather, it is optimal if it can create greater long-term value to shareholders than a contracting or partnering type of transaction.
Porter uses specific terms for establishing a framework around vertical integration. An upstream firm is the selling firm and a downstream firm is the buying firm. He also establishes terminology for directionality. Backward integration generally refers to direct investment in core supply elements (e.g. raw material production) necessary to produce a product or service. Forward integration generally refers to direct investment in the distribution channel and/or customer facing features of a service or product.
Finally, Porter warns of five common misperceptions about the perceived benefits of vertical integration:
- A strong market position in one stage can automatically be extended to the other.
- It is always cheaper to do things internally.
- It often makes sense to integrate into a competitive business.
- Vertical integration can save a strategically sick business.
- Experience in one part of the vertical chain automatically qualifies management to direct upstream or downstream units.
Using Porter's framework, Tesla is very clearly the downstream (buying) firm and SolarCity the upstream (selling) firm. Less clear is whether the acquisition provides for forward integration, backward integration, both, or neither.
Tesla and Solar City Communications Regarding Vertical Integration Benefits
In Tesla's initial June 21 blog announcing the deal, Tesla states the following:
"We would be the world's only vertically integrated energy company offering end-to-end clean energy products to our customers. This would start with the car that you drive and the energy that you use to charge it, and would extend to how everything else in your home or business is powered. With your Model S, Model X, or Model 3, your solar panel system, and your Powerwall all in place, you would be able to deploy and consume energy in the most efficient and sustainable way possible, lowering your costs and minimizing your dependence on fossil fuels and the grid."
In a follow up conference call on June 22, Elon Musk elaborates:
"And it just became increasingly obvious that as we're developing the Powerwall and new versions of the Powerwall, particularly as we integrate more of the inverter electronics and intelligence in the Powerwall, you really need to take the solar panels and the solar system into account when doing that. Otherwise, you duplicate a lot of hardware that doesn't work together as well; it's more expensive; the installation cost is substantially higher since you've got to put the solar Powerwall, solar panels and if you got an electric car, you've got to install the Wall Connector and at home charging system. Those are potentially three visits or at least two visits."
Tesla describes sales integration benefits in the blog:
"SolarCity's wide network of sales and distribution channels and expertise in offering customer-friendly financing products would significantly benefit Tesla and its customers."
In the June 22 follow up conference call, Musk says:
"And then, in terms of the sales process itself, when we're selling somebody the Powerwall, very often if not almost always, they're curious about solar and want to do the same things. So then, not being able to sell them solar directly at SolarCity - sorry, at Tesla through our stores is pretty inefficient. But I think as you look ahead to say Model 3, a $35,000 car, well that same person at the same moment, we could sell them roughly an equivalent amount value of solar panels and Powerwall effectively doubling, or almost doubling the sale at that time and then putting all in at the same time."
Finally, Musk speaks of Tesla's goal of being the world's best manufacturer and the extensibility of that competency to SolarCity:
"So, at Tesla, we're - a lot of that's been to become a world's best manufacturer. And I really mean that. That's like I'm highly confident we will be the world's best manufacturer. And I said we would build the world's best car, we did that. At SpaceX, I said we'd build the world's best rocket, we did that. We are going to be the world's best manufacturer, not by a small margin but by a margin that people don't even think is possible. And I believe in taking a first principles physics based approach to analysis. And my analysis of the situation is that dramatic improvements are possible on the automotive side and on the photovoltaic side."
Analysis of Potential Vertical Integration Net Benefits
Based upon the above publicly issued statements, what follows is a) an attempt to group Tesla's references to vertical integration into distinct categories and b) identification of each vertical integration category as either forward integration, backward integration, or neither; and c) an assessment of the merits of Tesla's arguments for value creation.
Vertical Integration of Product Offerings
Tesla Power, a business unit of Tesla, has developed the Powerwall technology which provides storage of electricity collected by SolarCity PV arrays. Arguably, a Tesla purchase of SolarCity is forward integration with Tesla investing in a distribution channel that may have needs for Tesla Power's storage and connectivity technology offerings.
The integration benefits and value added potential of this play appears to rely upon two primary factors:
A recasting of the SolarCity offering to include energy storage to a much larger degree than has occurred in the past. A tighter or exclusive supply agreement for Tesla Power to supply SolarCity with energy storage units (like the Powerwall).
These potential net benefits are challenged on multiple fronts.
- Tesla and SolarCity have previously presented this bundled offering (solar panel and storage) to the marketplace without the need for an equity investment.
- There is little evidence to suggest that combining Tesla and SolarCity will provide additive revenue growth
- Other residential rooftop solar companies may negatively react to Tesla Power being the exclusive supplier of storage technology to SolarCity. Future Powerwall sales to non SolarCity solar companies may be negatively impacted.
Vertical Integration of Sales Resources
Tesla's reference to combining the sales process for the Tesla, Powerwall, and SolarCity rooftop panels is, in fact, a combining of product sales under one umbrella. Tesla references a) roof-top solar arrays being sold in Tesla stores and galleries, and b) a push of Tesla sales through"SolarCity's wide network of sales and distribution channels."
The apparent benefits of this sales integration are the ability to have the same sales force pitch Tesla vehicles AND Powerwalls AND rooftop solar arrays. The value creation potential appears to rest in Tesla's potential to lower sales costs per revenue dollar.
These perceived benefits are challenged on multiple fronts:
- Tesla professes that it uses its store locations and galleries to educate customers about electric vehicles. In some cases regulations actually preclude Tesla from selling its cars at company owned stores or galleries. Tesla's current and primary sales channel is online sales, thus making the "joint sale value" from Tesla stores problematic.
- SolarCity has already tested "co-located" selling in its partnerships with Home Depot (2,200 stores in North America) and Best Buy (1,000-plus stores in the U.S.). The Home Depot and Best Buy co-location strategies arguably provide greater product linkage than would selling rooftop solar installations from a car showroom or from selling electric cars through a rooftop solar sales channel, as envisioned by a Tesla/SolarCity acquisition. Furthermore, Tesla only has approximately 100 company stores and/or galleries in the U.S, making the value added potential highly questionable in Tesla stores. The references to Tesla sales through SolarCity distribution channels are so murky as to be nearly impossible to assess.
- It is not at all clear why Tesla's plan for a joint sell necessitates the acquisition of SolarCity. Such an arrangement could be easily made on a transactional or partnership basis in the same way that partnerships were struck with Home Depot and Best Buy without necessitating an acquisition and the related capital costs.
"Vertical Integration" of Manufacturing Capabilities
The extension of Tesla's manufacturing competencies to SolarCity appears to be a knowledge transfer opportunity rather than a forward or backward integration play. SolarCity is in the early development stages for manufacturing PV cells. These PV cells are not an element of Tesla automobiles or Tesla Power products (at least at this time), thus this is not a backward integration. The implication is that by purchasing SolarCity, Tesla can enhance SolarCity's nascent manufacturing capabilities.
The perceived net benefit from integration is that Tesla would be well positioned to share its superior manufacturing competency with SolarCity, enhancing quality and lowering costs.
These perceived benefits also are challenged on multiple fronts:
- It is questionable that at this point in its evolution Tesla has unique or best in class manufacturing competency in automobile and/or storage module manufacturing.
- SolarCity has only recently extended its scope into manufacturing, namely PV cell manufacturing. There are now many global companies that manufacture PV cells. Much of the cost reduction in PV cell manufacturing has been achieved through manufacturing innovation. The incremental go-forward value to be gained through additional manufacturing enhancement is questionable, nor is it readily apparent that this enhancement can be realized through knowledge transfer from Tesla, an automobile manufacturer and battery manufacturer.
- It is not clear that Tesla's acquisition of SolarCity is the optimum transaction for knowledge sharing of manufacturing practices. Technology licensing, joint-venturing and contract manufacturing all seem to be feasible options that do not require Tesla equity.
High Level Valuation Estimates of Integration Benefits
When announced, Tesla valued the stock acquisition of SolarCity at $2.5 - $3 billion. At the time of the offering this purchase price represented a premium of 21-30% to the closing price of SolarCity. Thus, Tesla values the incremental integration benefits at roughly $400 million. A high level buildup of the potential financial benefits of the Tesla/Solar City combination is as follows:
- The forward integration benefit of a tighter bundling of Tesla Power's energy storage offerings with SolarCity's rooftop solar offering suggests an opportunity to increase the sales of Tesla power storage modules (i.e. Powerwall). The strategy requires a higher bundling of storage with solar than is now occurring. Understanding Tesla's estimate of incremental Powerwall cash flow benefit (rather than revenue benefit) would certainly shed some light on whether the valuation is too high or too low.
- The forward integration benefit of combined sales efforts between Tesla and SolarCity is realized primarily through consolidation of Tesla/SolarCity sales efforts, resulting in lower sales costs per unit of revenue. However, there remain many outstanding questions as to what existing SolarCity direct sales efforts (and associated costs) would remain after a Tesla/SolarCity combination. Additionally, it is not at all clear that the continued rapid growth of SolarCity installations could occur with a reduced sales effort (on a per unit sold basis) and/or sales footprint. SolarCity's most recent 10-K forecasts higher sales costs to fund growth.
- In 2015, SolarCity had $457 million in sales and marketing expenses and Tesla had sales, general and administrative expenses of $922 million. In Tesla's June 22 conference call, Musk said "if we are selling Powerwalls and solar systems of comparable value and doing so in the same sales footprint with the same person, the first order approximation, our cost of sales should drop in half as would SolarCity's correspondingly; maybe it's not entirely in half, maybe it's 30% to 40%." It is assumed that the majority of these savings would be realized by a) headcount reductions; and/or b) foregoing new sales staff hiring. No specific mention has been made to headcount reductions associated with the Tesla/SolarCity combination, or, alternatively, accelerated sales volumes using existing sales resources. Understanding these details would shed light on whether the SolarCity valuation is too high or too low.
- The knowledge transfer benefit around manufacturing expertise is, as previously stated, questionable at this point in Tesla/SolarCity's evolution. Furthermore, it is not clear whether the knowledge transfer will yield revenue enhancements or cost reductions. It seems premature to speculate on whether there is financial value for this perceived benefit. Having Tesla provide more detailed financial projections around this integration parameter would help inform the SolarCity valuation.
There has been considerable discussion and concern around whether the Tesla/SolarCity combination provides true vertical integration benefits.
My deeper dive into Tesla's explanation of vertical integration benefits yields little to mitigate this justified skepticism. Furthermore, a high level attempt to value potential vertical integration benefits provides little basis to justify Tesla's valuation of integration benefits. Finally, along the value parameters analyzed, Tesla's professed value creation strategies do not seem to require an acquisition of SolarCity. The strategies can be achieved on a contractual or joint venture partnership basis. This would avoid locking up Tesla and SolarCity on internal transactions only, allowing both companies to fully exploit opportunities with other market actors.
Tesla's rationale for acquiring SolarCity may be impacted by each of the "common misperceptions" of vertical integration that Michael Porter identifies, calling into question the net benefits of a Tesla acquisition of SolarCity. This leads to the conclusions that a) Tesla either does not understand the vertical integration benefits of a Tesla/SolarCity combination, or b) Tesla is not effectively communicating the value proposition behind a SolarCity acquisition, and/or c) there are alternate reasons for a SolarCity acquisition that Tesla has not explicitly disclosed (which relate to the opacity and governance issues raised by others).
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.