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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Solar City ( Nasdaq - SCTY ) -- Losing Money Despite Massive Subsidies

Solar City's stock (SCTY $32.00) has quadrupled in price since it became publicly traded last fall.  The company has done a masterful of job of influencing Wall Street expectations.  In the March quarter a loss of $.36 a share was reported (adding back stock option expense).  Sales improved 21% to $30.0 million.  The shares surged in advance of the report and maintained most of those gains despite the relatively dismal showing.  Gross margins narrowed by 7% on the solar systems the company sold in the quarter.  The gross margins on leased installations, which are depreciated over 30 years, also fell by 5%.  (For income tax purposes, depreciation is taken on an accelerated basis over 6 years.)  Solar City reported it cut production costs significantly.  The only explanation for the reduced manufacturing margin is sharply lower selling prices.  Selling and administrative expenses climbed 40% in the March quarter.

Solar City's explanation is that most of the "profit" it generated was deferred into future years.  The company's leased systems require homeowners to pay monthly fees for electricity that escalate at a 2.9% annual rate over 20 years.  Solar cell efficiency, using today's technology, generally deteriorates 2%-3% a year as a result of use.  Solar City uses financing partners that take advantage of the 30% tax credits issued by the U.S. Treasury for solar installations.  The company still pays interest on the balance, which it projects to decline from current levels.  The company is installing systems at a rapid pace, to be sure.  If the payment stream holds up, and the re-sale value of the systems is as good as the company expects after the initial 20 years, (recall, depreciation is taken over 30 years), and market interest rates don't rise, earnings could develop at some future time.

U.S. Treasury subsidies are scheduled to end in 2016.  That will force costs to decline by 30% just to break even on current pricing, which still is inadequate to produce a profit.  More worrisome, Solar City is betting against the likely trend in solar technology advances.  Modest improvements won't upset existing buyers.  But if nanotechnology based cells or other advances make it into mass production huge gains in efficiency could be achieved.  Those units could make today's systems look like horse and buggies.  Solar City no doubt would hire swarms of lawyers to force its existing customers to stick with their old fashioned systems.  But enormous write offs could occur if that effort fails.

Solar City's antagonistic approach toward the utility industry is likely to breed further trouble.  Electric utilities to date have put up with the inefficiencies and poor economics associated with solar power.  But as more homes go off the grid that accommodative policy is unlikely to continue.  Over the long haul the utilities themselves are almost certain to become solar installers to keep control of their networks.  Independents like Solar City may wind up resigned to serving niche markets.

The Enron style of accounting used by Solar City presents additional concerns.  For years Enron was the apple of Wall Street's eye, even though few if any of the analysts following the company were aware of its off balance sheet activities.  Every analyst we've talked to about Solar City can't explain the company's financing partnerships, either.  Perhaps they're structured to generate a huge windfall in the future.  More likely, they entail a complex structure with a variety of danger points.  These shares probably will fare well as long as the music keeps up.  Enron was a high flier for nearly a decade.  We think investors are playing with fire when it comes to these shares, though.  Better speculations are available.

Under Construction: The State of Solar

By Eric Ramsley  

The Los Angeles freeway system is in disarray. There is a lot of work that needs to be done. But there is so much traffic that there isn’t a whole lot of time to get anything fixed. Even when roads are temporarily shut down, like the 405 was earlier this year, no discernible progress is made. And by the time any construction is finished it will be time to start all over again. The roadways resemble the handful of Frankenstein cars driving along them: Pieced together with spare parts and clinging to dear life, unrecognizable from what they once were.

Swap out a few words and you’ve got the United States’ power grid. A jerry-built electrical network owned and operated by competing companies that is being stretched to its limit. Improvements have been proposed, but much like the highways in Los Angeles, by the time they are complete it will be time for the next round of emergency surgeries. Some have suggested that the grid’s poor state leaves it vulnerable to a terrorist attack; others argue that it is so shoddy and unpredictable that such an attack might ultimately fail.

Los Angeles is so developed that replacing the highways is highly improbable, if not impossible. But it’s at least conceivable that a new power grid could be built around the existing one, with the old system providing power up until the new system is complete. The benefits should outweigh the costs. The U.S. could have a state-of-the-art grid in place, securely and efficiently meeting increasing demand. This would also keep power companies in control of distribution. As much as some of them seem to want to believe it, the current setup will not be around forever.