SolarCity (NASDAQ:SCTY) is already the dominant player in residential solar and it's trying to build a large enough reach to stamp out any potential competition. Last month, that meant buying direct marketing company Paramount Solar for $120 million in order to improve the way it reaches customers. Yesterday, it made a move to further vertically integrate by spending $158 million to buy solar-racking maker Zep Solar, which is used by its competition.
You read that right: SolarCity is spending $158 million on a company that makes racking for solar panels and inverters. There's no incredible technology advantage, just a patented design that manufacturers can conform to in order to be "Zep Compatible." Some of the biggest names in solar like Trina Solar (NYSE:TSL), Yingli Green Energy (NYSE:YGE), Canadian Solar (NASDAQ:CSIQ), Sharp, and others make Zep-compatible modules. So, if Zep can become an industry standard, SolarCity can collect licensing revenue from the design.
Is this the right strategy in solar?
This isn't just a move to buy a product used by competitors. SolarCity is trying to lower costs by buying the manufacturer and standardizing its own design. CEO Lyndon Rive told GTM Research yesterday that Zep has "doubled throughput" by making it faster to install a solar system.
The challenge is that now SolarCity owns more of the supply chain. Now, it has to be a world-class installer, manufacturer, finance company, and sales organization. It's making these vertical acquisitions while competitors are taking the strategy of perfecting their own moat.
Sunrun and Clean Power Finance have taken the approach of perfecting financial arrangements through many downstream installers and providing those installers with useful quoting software. Neither company is interested in "owning the trucks" or doing the selling of solar systems themselves. They think it's more efficient for local companies to do that work.
Meanwhile, SunPower (NASDAQ:SPWR) is vertically integrated through the module and provides financing and training, but leaves most of the sales and installation work to its partners.
We don't know yet which strategy is going to work best but it's easy to punch holes in each. One key for SolarCity in making this a worthwhile acquisition is making Zep an industry standard, which may be more challenging now that it owns them.
One reason to buy Zep
The $158 million price tag for a racking company seems steep, but if we run a few numbers it looks a little more justifiable.
Let's say that owning Zep allows SolarCity to cut costs by $0.10 per watt on each installation. This could be from efficiency or capturing Zep's own margin. Now multiply that by the 270 MW of solar the company intends to install this year and you get cost savings of $27 million. That's just 5.9 times the purchase price, not an outrageous multiple. Assuming the company continues to grow quickly over the next few years, this could be a steal of a price.
Industry backlash is coming
SolarCity may be buying the standard bearer in racking but that doesn't mean the whole industry will come along willingly. Sunrun and Clean Power Finance will undoubtedly be less than pleased about financing projects that directly pay a competitor, and SunPower already has a contentious relationship with SolarCity due to personnel poaching years ago. Then there's the second largest solar installer, Vivint Solar, which currently uses Zep equipment but has ample reason to choose a new supplier now.
For Trina Solar, Canadian Solar, and Yingli Green Energy there are challenges as well. Do they go along with standardization to please SolarCity, potentially alienating customers who choose a different standard? Or do they make multiple SKUs to please everyone, effectively increasing their own costs?
Buying Zep may sound like a great acquisition, and it may be for SolarCity internally. I just wouldn't expect the whole solar industry to willingly accept Zep as a standard now that SolarCity owns it. In fact, the opposite may be true.
Foolish bottom line
I don't think racking is a game-changing strategic advantage for SolarCity, but it may make sense financially and help the company lower costs. It just doesn't mean competitors will suddenly be buying SolarCity products.
There are dozens of companies working to lower the cost of components like racking and module makers are also building some structural functionality into their modules. It's an interesting buy, just not one that changes the game for anyone in solar.
Fool contributor Travis Hoium manages an account that owns shares of SunPower and personally owns shares and has the following options: long January 2015 $5 calls on SunPower, long January 2015 $7 calls on SunPower, long January 2015 $15 calls on SunPower, long January 2015 $25 calls on SunPower, and long January 2015 $40 calls on SunPower. The Motley Fool owns shares of SolarCity. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.