This Just In: Upgrades and Downgrades

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

Buy SolarCity... Wait. Didn't you hear us? We said "buy," not "sell!"
 A funny thing happened on the way to the weekend. Last week, Goldman Sachs initiated coverage of solar power service company SolarCity (NASDAQ: SCTY  ) , hyping the stock's "unique financing model," its "declining input costs," and its ability to "grow installation volumes at a 30%-35% CAGR through 2016." And of course, urging investors to buy it.

And why is that funny? Because, as a matter of fact, Goldman Sachs had already said all of these things about SolarCity the last time it "initiated" coverage of the stock... nearly a month ago.

Funny thing
There was just one problem. When Goldman initiated coverage of SolarCity back in early January, the stock predictably jumped in response, gaining more than 10% in a day. But it then proceeded to drop, eventually falling below even the price it had fetched when first Goldman told people to buy it.

Seeing as Goldman underwrote at least 4.8 million shares of SolarCity's IPO, you can understand why the banker might find this a distressing development, and why it might decide to remind people: "Hey! We said buy the stock, not sell it!"

And if truth be told, Goldman does have a point here. SolarCity is growing its business at a pretty phenomenal rate, with revenues up 72.5% year over year last quarter. Goldman's also right about the declining input costs, which should in theory enable it to earn more and more profit the more solar panels it sets up and the more customers it brings on line (or off-grid, depending on how you look at it).

In recent weeks, solar specialist Axiom Capital Research has issued a number of dire warnings about the state of the solar industry upstream from SolarCity. Power inverter maker Power-One (NASDAQ: PWER.DL  ) , for example, has seen its revenues decline by 34% between Q3 2012 and Q1 2013. Solar module makers such as Trina Solar (NYSE: TSL  ) , which are trying to hold the line on pricing and preserve their revenues, are being challenged by a utilities end run, and losing sales to other Chinese vendors who are more willing to play ball and sell for lower prices. Meanwhile, even farther upstream, Hemlock Semiconductor, a subsidiary of the joint venture between Dow Chemical and Corning, which makes polycrystalline silicon, appears to be looking at Q1 2013 silicon sales that are just "half" of what it made in Q4 2012.

That's not going to be good news for Hemlock's parent companies, of course. But for a company like SolarCity, which is buying all of this stuff from the solar power equipment companies, it means lower costs, and higher profits.

Theory... and practice
Or at least, that's what it should mean. But what do we see instead at SolarCity? Well, the company's just about doubled its revenues over the past 12 months. But instead of raking in the profits on these extra revenues, SolarCity turned its $43.5 million 2011 net profit into more than $47 million worth of losses over the past year.

And that's the good news. The bad news is that when we turn to the cash flow statement, it's apparent that SolarCity's burning much more cash than its income statement lets on: More than $400 million in negative free cash flow from 2009 to 2011. More than $315 million in cash, up in flames over the past 12 months alone.

A fatal flaw?
How could this happen? The reason is neatly summed up in an analysis of the company's business model from Needham & Co. -- coincidentally published at the same time as was Goldman's initial buy recommendation: First, SolarCity installs solar panels on a customer's building, footing the cost of equipment and installation itself. Then... "SolarCity [offers] solar leases at lower rates than retail electricity."

This simultaneously explains why the company's product is so popular, and its revenues growing so quickly, and also why SolarCity is losing money on the proposition. It's easy to find customers when you're offering to sell them something at a discount, with no downside to the deal. It's harder to make a profit, when you're selling the product for less than the going rate. That's just common sense.

It's also a real problem for SolarCity. A buy rating from Goldman -- or even two of 'em -- can't change the laws of economics.


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