Sunday, February 23, 2014

Solar City (Nasdaq - SCTY) -- Makes it up with Volume

Solar City (SCTY $77.00) is a leading installer of residential solar systems.  The company also builds larger units for commercial, military, and industrial applications.  Solar City operates exclusively in the United States.  Solar power has become more competitive with utility supplied electricity since the 2008 recession.  The cost of solar panels plummeted due to excess supplies in China.  Providing further impetus was a 30% federal tax credit contained in the 2009 federal stimulus package.  The amount of electricity produced by solar systems is greatest in warm sunny regions.  But the units have proven competitive in northern climates, as well, because those areas tend to endure much higher utility prices.  Unit volume has been robust throughout the country.

( average output per 1 kilowatt system )

Solar City usually retains ownership of the residential systems it installs.  Homeowners have the option to buy.  But pricing is structured to drive business to the company's leasing model.  No down payment is required.  Homeowners simply agree to use the solar energy.  If that runs out, then they can tap the utility grid.  The purchase contract usually sets a price below the current utility rate.  Escalators of 2%-3% a year customarily are built in.  If the solar system produces more electricity than the homeowner needs, most states require the local utility to buy it at retail rates ("net metering").  Solar cells degrade 2%-3% per year.  That reduction in output is offset by the escalating price in the lease agreement.  Revenue is expected to remain consistent over the 20 year life of the deal.  At that point customers have an option to buy the system.  Or Solar City will remove it.

The industry is highly competitive.  All the equipment that goes into a solar system is available from multiple sources.  It has standard specifications.  Installation techniques don't vary.  Local building codes have to be satisfied.  And marketing expense is steep, averaging $2,500 out of a total cost that averages $25,000.  (If they were sold the retail price probably would be around $33,000.)  Most competitors use the same pricing strategy.  But they usually sell the systems to profitable financial entities that can utilize the 30% tax credit (plus whatever the states offer).  The federal government also allows solar systems to be depreciated on an accelerated basis, over 6 years.  Those deductions are attractive to financial buyers, as well.  (The U.S. Treasury does not allow individuals to take depreciation deductions.  That gives an economic advantage to corporate entities.)

Solar City follows a high risk, high return strategy instead.  The company retains ownership of the systems, hoping it will earn a bonanza in 8-10 years.  A series of complex off-balance sheet partnerships have been established under which Solar City borrows cash from financial investors to build out its network, and gives them the tax benefits.  That reduces the amount that needs to be borrowed.  Cash flow from the systems is directed towards repaying the loans.  That pays down the debt.  But it causes operating losses to expand as volume increases.  So more cash needs to be raised to finance the next round of installations.    In 8-10 years enough income will be freed up, as today's systems are paid off, to allow the company to start reporting profits.  Income could surge in the early part of the next decade.

The largest risks are political.  The 30% federal tax credit is scheduled to decline to 10% in 2017.  Several states are considering a reduction in their subsidies, too.  It's unclear if Congress will pass a new law to restore the 30% credit.  Every percentage point removed would translate into a percentage point of lower profit margin, unless the price charged for electricity is increased.  Solar City hopes to reduce operating costs enough to compensate for any reduction.

The net metering debate creates more political uncertainty.  Utilities around the nation have begun to argue that solar and wind power are disrupting their grids' efficiency.  They also say that other customers are being forced to pay more than they should, because the utility is required to repurchase power for wholesale purposes at retail prices.  In most states the retail price is 3x the wholesale.  If solar systems can't sell their surplus electricity at full price in future years, the reduction could impair the overall economics of the lease deal.

Solar City is hoping to develop lithium battery back-ups to alleviate the net metering threat.  If the government subsidizes the batteries a move like that could prove beneficial, both to the solar companies and the grid operators.  Adding a battery would make the entire system cost more, though.  Whether there still would be enough room to discount from the utility's electricity rate is uncertain.

Low cost natural gas produced by the fracking revolution presents an economic challenge.  Solar City established its business plan before natural gas was developed in abundant quantities.  It expected electricity rates to keep increasing the way they had been.  The advent of low cost natural gas has put a ceiling on utility rates, though.  If the escalators in the company's contracts drive its price above the utility's, a variety of unforeseen problems could arise.

Longer term, next generation solar technology could make the company's installed base obsolete.  Sleeker, more efficient systems are likely to be introduced before the end of the decade.  Existing customers might be willing to live with their older units.  But they could become an albatross when it comes time to sell the house.  Maintenance and upgrades could be an expensive proposition for Solar City down the line.

Solar power is likely to become a major component in the country's energy mix.  Substantial growth is likely.  Solar now accounts for 1% of the United States's energy supply.  In ten years that figure might reach 5% or more.  If everything breaks right Solar City could become a highly profitable industry leader in 8-10 years.  Right now, though, the company is losing money on every sale.  It is surrounded by risk.  The stock's valuation is high, at 26x our estimate of 2014 revenue.  Our advice is to stay on the sidelines.

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Monday, February 17, 2014

Tasman Metals ( Nasdaq - TAS ) -- Rare Opportunity

Tasman Metals (TAS $1.10) is the leading developer of rare earth mining facilities outside of China.  Rare earths are key ingredients in electric motors, smartphones, and a wide range of other green energy and high technology products.  More than 90% of the world's current supply is found in China.  The government there has used its ability to corner the market to extract a variety of concessions over the years.  The scarcity of the material also has created pricing volatility.  China still has abundant resources of lighter rare earths, which generally are less valuable and easier to replace with alternative technologies.  Its heavy rare earth supply has started to dwindle, however, and may only have 10-15 years remaining at current rates of consumption.  Tasman Metals, relying on advanced computer simulation methods, discovered a huge reserve of heavy metals in southern Sweden in the late 2000's.  The company obtained exclusive rights to the property.  The entire reserve has been delineated with exploratory drilling.  A 40 year supply has been identified.  The initial chemistry has been positive.  Rare earths are mixed in with ores and other kinds of rocks that need to be separated out.  Rare earths also must be oxydized into a commercial form to establish the magnetic force required by the high tech products they go into.

Scale up testing will begin early in 2014.  Tasman recently raised additional capital to expand throughput and demonstrate its ability to produce high volume quantities at prices that are acceptable to the market.  Alternative solutions exist.  At this point those methods cost significantly more than rare earths.  For Tasman to be successful it will have to keep costs below those other approaches.  A handful of other non-Chinese reserves have been located during the last decade.  Two are in northern Canada.  A third lies in Greenland.  Those reserves have not been developed to date due to substantially higher capital costs than Tasman faces.  Since other options to rare earths exist, those sites may never be mined because of their remote and harsh locations.  Recycling of rare earths takes place today but represents a small competitive factor.  Approximately 1%-2% of the world's supply is generated in that fashion.

A large corporate partner is likely join the project if this year's scale up effort proves successful.  Capital expenditures to develop the Swedish mine are expected to total $250 million.  (The sites in Canada and Greenland are believed to require $1.2-$1.5 billion.)  Tasman probably could borrow most of that and develop the project itself.  Taking on a partner would reduce risk, however, and provide expertise and marketing outlets.  Several interested parties already are lined up.  Demand for the company's heavy rare earths is likely to be robust, particularly in Germany and Japan.  Some financing may be provided by "off take" agreements where customers provide cash to develop the enterprise and receive rare earths as payment down the line.

Sales could attain $125-$150 million a year once full production is achieved in 2016-2017.  Tasman still is debating whether to employ an open pit or underground mining approach.  Sales could go higher if the open pit method proves economical.  If Tasman were to operate the entire project itself fully taxed income could reach a $.75-$1.25 a share run rate, depending on how many shares it had to sell and how much it could borrow instead.  A 50-50 joint venture could yield income of $.50-$.75 a share.  Long term sales contracts probably could be signed with multiple customers, ensuring steady recurring revenue.  Rare earths are a proven commodity in the high tech industry.  Even if alternative methods for creating magnetic fields are invented they probably would face a slow adoption curve as long as reasonably price rare earths were available from non-Chinese sources.

These shares entail a high degree of risk.  Tasman may be unable to refine its heavy metals economically.  It's possible the Chinese will develop new heavy rare earth reserves, raising competition.  Lower cost alternative technologies could emerge, although those are difficult to visualize at this time.  The main risk is internal.  If Tasman can deliver the goods, exceptional investment returns are possible.  The next key milestone will occur later this year when results from the current scale up effort become known.

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Saturday, February 8, 2014

Superconductor Technologies ( Nasdaq - SCON ) -- High Wire Act

Superconductor Technologies (SCON $2.50) appears to be the technology leader in the manufacture of high temperature superconducting ("HTS") wire.  Volume production is scheduled to begin in the June quarter.  Superconductors carry 10x more electrical current than conventional copper or aluminum cables, with superior efficiency (less juice lost during transmission).  Until now the technology required cooling systems that approached absolute zero, making them impractical for business applications.  Superconductor Technologies may have cracked the code, however, enabling the higher performance to be achieved with standard cooling mechanisms that are reliable, easy to maintain, and inexpensive.  Pilot plant production has been underway for the past year.  Potential customers in several industries have been testing those wires.  Many are engineering new products in which HTS wire is the key component.  The company's production line will be modular in nature, enabling it to raise output in a methodical way if demand materializes.   Markets that are being addressed right now include electric utilities, medical equipment, high performance windmills, and electric motors.  New markets could emerge if Superconductor Technologies is able to reduce costs down the road.

An entirely new product for the utility industry could be the first application.  A leading maker of utility equipment has developed a line of "fault current limiters" that smooth out abnormal electricity flows and protect substations from failure.  The threat of faults and blackouts has increased in recent years due to a variety of factors, among them the addition of renewable energy sources that flood the system at some times and go dark at others.  The threat of terrorist computer hacking and sniper attacks pose additional problems.  Fault current limiters behave like gigantic surge protectors.  Besides guarding existing sites the new technology is expected to shrink overall capital costs by reducing the amount of back-up equipment.  Longer term, utility customers may employ superconductors in transmission cables, as well.

MRI machines represent another large possible market.  Better imaging could be obtained at lower costs.  Offshore wind farms are a likely target, too.  Wind technology has barely improved since 2000 because generation gains require longer blades and bigger generators.  HTS wires could raise power density and sharply reduce generator weight, enabling larger turbines to be constructed.  The offshore market is thought to hold the greatest potential.  Electric motor producers also are examining the technology.  Superconductor Technologies currently is working with eight prospective customers altogether.  Each one is believed to be capable of buying 100% of the company's output once production begins in Q2.

Superconductor Technologies's initial full scale production line is expected to generate $35-$40 million in sales at current prices.  A modest capital expenditure could double output, creating a full modular package yielding $75 million annually.  The company has ample space in its facility to add more lines.  Each is expected to cost $12.5 million to build.  Gross margins are anticipated to reach 60% to start and improve to 90% once efficient operation is realized.  Overall profitability is expected at the lower rate.  Selling prices are likely to remain hefty for a while due to a lack of competition, and relatively high costs.  Most customers are asking for custom designed wires, which will keep production runs short.  Superconductor Technologies hopes to establish a standard format over time, enabling longer runs and reduced expense.  That could facilitate significant price reductions while preserving attractive margins, opening up new applications.

Our estimates assume the machine will work when the switch is pulled in Q2.  Depending on what kind of delays are encountered, sales for the year could reach $10-$15 million.  Orders are likely to exceed shipments by a wide margin.  Superconductor Technologies raised equity capital last fall.  Warrants covering 10.7 million shares are outstanding, as well, exercisable at $2.57 a share.  Sufficient capital is in place to support the initial launch.  The warrants could cover the next round of spending.

In 2-3 years sales could reach $100-$150 million to provide fully taxed earnings of $.50-$1.00 a share.  Joint ventures are likely to emerge, in addition.  The potential market for affordable high temperature superconductors is enormous.  Major industrial companies are virtually certain to pursue the technology, if it can be made to work.

These shares entail a high degree of risk.  The most likely outcome is a delayed product launch.  A lengthy setback could force the company to raise additional capital, creating dilution for shareholders.  A complete failure is possible.  Success, however, could yield unfathomable appreciation.  The pilot plant worked well.  The customers are excited with the wire's performance.  The design for the production scale line is locked down.  The components are scheduled for delivery to the company's Austin, Texas facility this quarter.  The launch date hasn't budged for the past six months.  Competitors exist.  But they are pursuing different methods that have shown little sign of success to date.

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