Valuing SolarCity Is More Complicated Than It Seems

SolarCity (NASDAQ: SCTY  ) is up by more than 535% since its IPO. Given that the company is still reporting losses, it's easy to think that its stock is expensive. However, there are some unique challenges to understanding what SolarCity is worth. Here are two issues to consider before attempting to value the stock.

Rise of the lease arrangements
In the past, going solar wasn't practical for many consumers due to the high costs of installing solar systems. In 2008, SolarCity introduced an option for customers to "go solar" with little to no upfront costs.  

This is done with lease and power agreement arrangements where customers pay monthly fees for the systems and power instead of buying equipment outright. According to Standard & Poor's, about 60% of SolarCity's revenue will come from these arrangements by 2015.

Many of SolarCity's competitors offer similar arrangements. For example, SunPower  (NASDAQ: SPWR  )  started to offer lease arrangements in 2011. SunPower has a market cap of $3.6 billion and $2.5 billion in annual sales. Real Goods Solar (NASDAQ: RGSE  )  is another example. The company has a market cap of about $96 million and annual sales of about $98 million.

Issue #1: earnings versus reality
Consumers seem to like the arrangements. According to SolarCity's most recent 10Q filing, over 90% of third-quarter solar system sales were done through lease agreements. The issue with these arrangements is that they're actually very complex. Here's an example of how the agreements are often structured at SolarCity.

  1. SolarCity creates a "financing fund" into which investors contribute money.
  2. The fund uses the money to buy solar power systems from SolarCity -- this generates cash and revenue for the company.
  3. The fund leases the equipment to customers and receives monthly payments from those customers.  
  4. The fund allocates to investors (that can include SolarCity itself) their respective shares of customer payments over time.
  5. Repeat.  

To top it off, established accounting standards handle these arrangements with special treatment. For example, while SolarCity may receive an upfront payment of $30,000 from a financing fund, that payment may be recorded as incremental revenue over time. In other words, it could be recorded as $1,000 in revenue per year for 30 years (to replicate a lease).

The result is that the revenue and net income on SolarCity's financial statements may not be an accurate reflection of its current sales and earnings. This can be observed by comparing SolarCity's net income to its cash flow from operations. 
 
Year 2009 2010 2011 2012 TTM
Net Income -26 -39 44 -64 -55
Cash Flow 2 -4 18 60 248

 Source: Morningstar, BCM

 
Notice that SolarCity's net income went from negative $2 million in 2009 to negative $64 million in 2012, but meanwhile its cash flow from operations went from $2 million to $60 million. Also note that cash flow more than tripled from 2011 to 2012 and has already quadrupled in 2013. 
 
In terms of valuation, SolarCity's negative earnings make it look expensive or impossible to value (its price to earnings ratio is -63.) However, in terms of cash flow SolarCity looks reasonable. Its price-to-cash-flow ratio is about 14, which is lower than the industry average of 17.  
 
The point is that net income may not be a reliable measure for valuing SolarCity because of how it recognizes revenue. Investors need to look beyond reported earnings to understand the company's actual results. 

Issue #2: monetization of tax benefits
The government offers various tax credits and incentives tied to the purchase and use of solar power. SolarCity is able to monetize these tax benefits by selling them to its financing funds for cash and recognizing the proceeds as revenue.

In other words, SolarCity makes money from what are basically government tax subsidies. The subsidies make it possible for SolarCity to offer no-upfront-cost solar systems with monthly payments that are less than those of incumbent electric power providers.

However, the tax benefits won't be around forever, and that's clearly an impending problem. SolarCity's management recognizes this as a significant risk. Consider the following statement from the company's most recent 10Q:

Reductions in, or eliminations or expirations of, governmental incentives could adversely impact our results of operations and ability to compete in our industry by increasing our cost of capital, causing us to increase the prices of our energy and solar energy systems, and reducing the size of our addressable market. In addition, this would adversely impact our ability to attract investment partners and to form new financing funds and our ability to offer attractive financing to prospective customers.

Ultimately, this variable is tied to unpredictable legislation. How do you price that risk into valuation? What's the "discount rate" for uncertain government policy? It's complicated and subjective to say the least. In SolarCity's case, it is also something that must be considered. 

The bottom line
As with any investment, I think it's crucial to have a clear understanding of how a company generates profits, not just today but also into the future. Without that, it's hard to determine fair value for the stock.  

This is all easier said than done for SolarCity, where revenue and earnings are complicated by a mix of funds, investors, taxes, and accounting quirks. At the very least, I'd want to know how SolarCity plans to attain profitability without government subsidies.  

That being said, this isn't a recommendation for or against SolarCity. I'm just pointing out that SolarCity is more complicated than it may seem. Those considering an investment in SolarCity should look beyond the headlines and reported numbers to develop a genuine understanding of the business and its long-term prospects.  

It's hard to put a value on growth like this
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  • Report this Comment On December 12, 2013, at 11:45 AM, drpaynedr wrote:

    As a new MF member, I’m just beginning to dig into the recommendations MF offers, and do a little of my own independent research on them. I’m confused about why some very significant risk factors for SolarCity seem to be ignored, or at least are not mentioned in this article and others on the same company. Quotes below are from the most recent 10K

    1. Potential adjustments to net metering

    There appears to be a growing backlash against net metering in states that have had these policies in place for a long while, such as in California and Colorado. Utilities and non-solar customers are beginning to more strenuously object to having to “purchase” power from residential solar customers at retail prices, rather than paying wholesale prices from other sources of power. And there is an increasing feeling that solar customers’ use of the grid for their usage beyond the solar power they generate happens without these customers paying their fare share of the costs of the grid.

    “In addition, any changes to government or internal utility regulations and policies that favor electric utilities could reduce our competitiveness and cause a significant reduction in demand for our products and services. For example, certain jurisdictions have proposed assessing fees on customers purchasing energy from solar energy systems or imposing a new charge that would disproportionately impact solar energy system customers who utilize net metering, either of which would increase the cost of energy to those customers and could reduce demand for our solar energy systems.”

    2. Rebates and Tax Credits

    While the article describes the likely end to these critical elements of SolarCity’s revenue stream, it neglects to mention that SolarCity may have been, and may continue to be ineligible to collect them on behalf of their end customers, may have incorrectly estimated the value of their installations for tax purposes, and may face very significant fines for these practice.

    “Our leases and power purchase agreements are third-party ownership arrangements. Sales of electricity by third parties face regulatory challenges in some states and jurisdictions. Other challenges pertain to whether third-party owned systems qualify for the same levels of rebates or other non-tax incentives available for customer-owned solar energy systems, whether third-party owned systems are eligible at all for these incentives, and whether third-party owned systems are eligible for net metering and the associated significant cost savings. Reductions in, or eliminations of, this treatment of these third-party arrangements could reduce demand for our systems, adversely impact our access to capital and could cause us to increase the price we charge our customers for energy.

    The Office of the Inspector General of the U.S. Department of Treasury has issued subpoenas to a number of significant participants in the rooftop solar energy installation industry, including us. The subpoena we received requires us to deliver certain documents in our possession relating to our participation in the U.S. Treasury grant program. These documents will be delivered to the Office of the Inspector General of the U.S. Department of Treasury, which is investigating the administration and implementation of the U.S. Treasury grant program.

    These risk factors have the potential to leave the company essentially without any value at all should they come to pass, not just an incremental reduction in value. I would like to know whether these factors were considered in the positive recommendation of SolarCity by MF, and if so, what the justification for ignoring them is?

    Thanks!

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