SolarCity's Greatest Move Was the One You Didn't Hear About

When you combine the near-celebrity status of Elon Musk and the red-hot solar-energy industry, it seems almost impossible that anything SolarCity (NASDAQ: SCTY  ) does would fly under the radar. Surprisingly, though, the company's acquisition of module installation Zep Solar hasn't garnered much attention. It's a shame, because this deal could mean more to its profitability than any other deal it has made this year. Let's look at why this deal was important and how it could help the company reach its goal of 1 million installed systems by 2018.

Seen a house with panels like this one? There's a 26% chance they come from SolarCity.

Buying a compliment, not a competitor
One of the biggest misconceptions about solar companies is that many investors lump them all into the same basket. Let's be clear: SolarCity, Zep Solar, and panel makers such as SunPower (NASDAQ: SPWR  ) are wildly different businesses that don't have as much overlap as one would think. Zep Solar specializes in manufacturing mounting and grounding equipment for panels, whereas Sunpower builds the panels themselves and SoalrCity is a panel user.

This is what made the move so attractive for both companies. For Zep Solar, SolarCity's market share in residential photovoltaic installations is greater than the eight next largest competitors combined, and it's targeting 1 million customers by 2018. The most recent quarterly release shows that the company has just over 82,000 customers. So getting there would result in a compound annual growth rate of greater than 75% for the next four years. To that end, getting hitched with SolarCity gives Zep Solar a built-in customer who will have a voracious appetite for its equipment. 

Converesly for SolarCity, it secures a source of mounting equipment for installations, reduces costs, and allows for standardization of installations that will in turn reduce installation time. Ultimately, this will translate into installation cost reduction, which represents 72% of cost of goods sold. In buying Zep, it's also buying the market leader in residential mounting equipment leader, which is a market that expects to grow by 16% annually over the next five years to as much as $1.5 billion. In reality, though, that is just a cherry on top of the cost savings.

The potential for cost savings on the installation side of the business cannot be overstated. Just look at the breakdown of company revenue.

SolarCity Q3 2013 Results ($Millions)
Revenue from operating leases 24.80
Costs associated with operating leases 8.43
Operating lease gross margin 66%
Revenue from energy system sales 23.80
Costs associated with energy system sales 22.64
Energy system gross margin 5%

Source: SolarCity Q3 2013 10-Q.

Low margins in energy systems sales is a product of the business model. Many of the offerings SolarCity provides involve zero upfront payments from the customer for panels and installation, which is what makes SolarCity so compelling to customers. The downside of this model is the company is forced to eat the installation costs, which you can see in the company's system sales gross margins. System sales alone will never be a highly profitable segment of the business, and investors shouldn't expect too much from this segment, either. But any significant cost control on that side will go a long way in increasing the overall profitability of the business. 

3 deals for 1 million customers
The Zep Solar deal itself isn't going to get SolarCity to 1 million installations because it doesn't really expand the customer base. However, the combination of this deal with the company's other recent moves, it paints a much rosier picture.

  • Zep Solar: Increasing the customer base by 12 times in four years will take more than just a spectacular sales team, the operations team will need to be fantastic as well. As I mentioned, Zep Solar provides a decrease in installation costs and reduced installation time. This will make the operations of the company more efficient and allow an individual crew to do more installations per year.
  • Tesla Motors (NASDAQ: TSLA  ) : Using Tesla's battery technology for on-site energy storage will reduce the issue of intermittent power generation. This will also allow customers to skirt net metering issues and provide extra power when panels can't generate power. Ultimately, it makes SolarCity's offerings more attractive to customers and will help keep its market share lead over competitors such as SunPower and NRG Energy (NYSE: NRG  ) that have been making a splash in the market as well. 
  • Wal-Mart (NYSE: WMT  ) : Can you name a better client to get 13% of your business from than the world's largest big-box retailer that wants to generate 7 billion kilowatt hours from alternative energy by the end of the decade? For the past couple of years, SolarCity has been cultivating a relationship with Wal-Mart and has done about 130 installations at Wal-Mart stores this year. With solar saving Wal-Mart $2 million a year on utility bills in 2012, you can rest assured that it will continue to tap SolarCity for more installations down the road. 

SolarCity estimates that 1 million customers would equate to about 6,000 megawatts of installations. That would be equal to all solar panel installations in the United States between 2010 and 2012, a very ambitious goal to say the least.  Besides, getting only halfway there would still equate to a jaw-dropping compound annual growth rate of 53%. 

What a Fool believes
The Zep Solar deal and the other ones SolarCity has made this year make no guarantee that it will get to 1 million installations by 2018, but they are a clear indication that management is pulling all the right levers to head in that direction. For investors in SolarCity, acquiring Zep Solar for just over $150 million may have not registered as too much of a blip on your radar, but the cost savings it could deliver to the company may very well be more significant to the performance of the stock than any other deal this year. Shares of SolarCity are up almost 375% this year, and investors would be crazy to think the company can repeat that performance in 2014. However, don't be surprised if the company posts impressive numbers as it reaches for that mythical 1 millionth customer. 

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Read/Post Comments (3) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 24, 2013, at 12:46 PM, greensunnj wrote:

    Very interesting article... Big question is: What happens to the half dozen or so PV panel manufacturers who signed multi-year deals to make Zep compatible panels [to sell to the open market]???

    Are companies such as Canadian Solar, Trina and ET Solar now locked into only one potential buyer (Solar City) or will they they be free to re-market the Zep product line under their license agreement?

    I would also be curious to know what Vivint's strategy will be - as they recently standardized on the Zep Solar mounting system.

  • Report this Comment On December 25, 2013, at 11:44 AM, Robordc wrote:

    The Motley Fools need to rethink SolarCity. This company exists only because of net metering, which is currently under scrutiny by state regulators. The problem with net metering is that it allows customers with solar generation to evade paying their fair share of the services provided by their utility. This, in turn, means that their neighbors without solar generation will be charged more to make up the utility's loss.

    If (most likely when) net metering is eliminated SolarCity's potential market will dramatically shrink, killing off its growth rate. It's stratospheric P/E ratio will quickly collapse, taking down a lot of investors in the process. SolarCity may well be another ENRON waiting to happen.

  • Report this Comment On December 25, 2013, at 11:42 PM, bcellars wrote:

    I did a quick read on net metering and think it's a complete 'non-issue', and is more likely to gain wider acceptance, not less. From Wikipedia "Minnesota is commonly cited as passing the first net metering law, in 1983", so it's not likely to suddenly disappear now. It's growing world-wide and is likely the way of the future.

    The argument that users "aren't paying their fair share of the grid cost" is also mostly nonsense. A simple solution would be to charge a 'grid fee' or 'connection fee', which would be a flat rate fee and the same for everyone, and then you pay for usage, and get paid for contribution. Currently however, the number of people "not paying their share" is minuscule. "In California, the leading solar state, only .77% of total utility consumers had net metered solar installations. In other strong solar markets, such as Arizona, Colorado, New Jersey, Nevada and Pennsylvania, net metered solar customers made up less than .5% of total utility customers in each state." So, what, that adds up to maybe a penny per user! :)

    I've been long SCTY since their IPO, and after reading up on net metering, I'm even more convinced of a bright future. Please do your own evaluation, and good luck.

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