Tesla's SolarCity Deal: Another Musk Gimmick Or The Real Deal?

| About: Tesla, Inc. (TSLA)
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Tesla is actually buying SolarCity for $2.6bn.

To a lot of people, this buyout doesn't make economic sense.

However, it all boils down to the battery question.

Tesla's (NASDAQ:TSLA) stupefying $2.6bn all-stock buyout of SolarCity (SCTY) has investors wondering: where exactly is the synergy between an electric vehicle manufacturer and a cash-strapped solar company that installs solar panels on the rooftops of suburban homes?

The answer lies in residential energy storage. According to a recently released Energy Monitor report by GTM Research, "the U.S. deployed 18.3 megawatts (21.2 megawatt-hours) of energy storage in the first quarter of 2016. Deployments were up 127 percent year-over-year, but down 84 percent from the historic fourth quarter of 2015." This deployment was also diverse, covering many new states besides California and Hawaii. Hawaii, especially, is important because the cost of regular electricity there is very high, and hence there is a greater need to find cheaper alternatives.

The problem with sustainable solar energy is that, by definition, solar energy is not a constant. It is available during the day and not available during the night. Like the old joke goes, the kid said that the moon is more important than the sun because the sun shines during the day, and the moon during the night, when we need light more. So also, the old problem with solar energy has been, how to store that energy for use at night and during cloudy days.

The answer lies in residential battery storage. However, right now, residential battery storage is extremely expensive, running into thousands of dollars - this article gives some data. Solar energy already has achieved "socket parity," meaning that it costs as much or less than regular electricity. The problem, however, is with "grid parity." That's the difference in the costs of storing solar power vis-a-vis regular electricity, which is constantly produced and doesn't depend on storage.

As the following graph demonstrates, some experts think that this may happen within the next few years, while others hold that this may not be possible for decades to come:

Source: GTM Research

Elon Musk is betting his entire reputation on the concept that once his battery gigafactory becomes operational in Nevada, it will, due to mainly economies of scale but also hopefully through an exchange of design ideas with SolarCity, be able to achieve substantial reduction in storage costs. Right now, ordinary residences in the US, despite seeing socket parity between solar and regular power, do not prefer to install storage because of the humongous costs of battery. However, if Musk's idea is executed properly, he claims there will be a huge synergy between SolarCity's battery technology coupled with Tesla's manufacturing capacity, which will be useful for its own business, as well as for SolarCity's solar panel power grid installation business.

If this happens, then, from the standpoint of SolarCity, batteries will become a standard part of the solar panel setup in all US homes, drastically dropping the ultimate price of solar power, making it available to all and sundry.

A grand idea, but the big question that keeps bothering me is: exactly how will Musk reduce the cost of batteries that cost thousands of dollars now, to something that shouldn't be more than a tenth of that price? Economies of scale sounds like a big deal, but simple business accounting tells me that it is almost impossible to bring in a ten-fold reduction in expenses to sustain a similar reduction in pricing unless there's a major change in the science behind. It is true that there's been a steep drop in battery prices over the ongoing decade, with a corresponding rise in capacity. Manufacturing efficiencies may further add to the cost reduction, and a 5,000-employee factory in Nevada is still not a 5,000-employee factory in, let's say, China. However, like I said, and like a bunch of other people are saying, will manufacturing efficiency alone, and simply using today's technology, be enough? Will today's science really be able to produce tomorrow's batteries? An entire research article can be written on this latter issue alone.

More to the point for investors, where will Musk get all the money and the expertise required to ramp up production, create a sustainable cash flow, deliver on the promised 373,000 Model S over the next few years, complete the $5 billion Nevada factory - all that without diluting existing shareholders?

But perhaps Musk knows something we don't. At least that is what Tesla investors will be betting on. For now, Musk is selling us a dream, and we are buying it lock, stock and barrel. So, while I like Tesla for that grand, all-inclusive futuristic dream, I stay wary.

Disclosure: I am/we are long TSLA.

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.