The debate about efficiency versus cost can be put to rest now that the largest residential solar installer in the U.S. has bought a "high efficiency" module manufacturer.

SolarCity (SCTY.DL) announced this morning that it is buying solar panel manufacturer Silevo for $200 million with $150 million in potential earn-out based on production and cost milestones.  

What's even bigger news is that SolarCity is already in discussions with the state of New York to build a solar panel plant with more than 1 GW of capacity within two years. This will be followed by around 10 GW in new production, or more than a quarter of all of the solar panels installed in 2013.  

This is a massive bet by SolarCity and a huge strategy shift by a company that once told me directly that efficiency wasn't a differentiator in solar. Let's look at what SolarCity is getting and what investors should know.

SolarCity's sights are set on dominating the entire value chain in solar. Source: SolarCity.

What SolarCity is getting
Silevo is a solar technology company that was launched in 2007 but didn't introduce a product until October of 2011. The company is headquartered in Silicon Valley but is building production in Hangzhou, China.  

According to the company's website, it manufactures panels with efficiency of up to 18.4% and has produced cells with 22% efficiency on a production scale. By the time the 1 GW factory is up and running, SolarCity expects cell efficiencies of 24%. This would bring panel efficiency to 20% to 21% (find out more about cell versus panel efficiency here). 

To put those numbers into perspective, SunPower (SPWR -8.41%) commercialized a 21.5% efficient panel last year, and pre-production cells have measured 25% efficient. A 23% efficient module is expected next year, with steady improvements beyond that. So, SolarCity will likely be within 3%-5% of SunPower's efficiency when they begin production. This won't lead the industry, but it's a step up from 15%-17% modules it is currently buying and puts it in the upper tier if targets are reached.

SolarCity's installers put up a residential solar system. Source: SolarCity.

Where SolarCity will take Silevo
Silevo already has a planned plant in Buffalo, New York, and SolarCity wants to expand the plant to a 1 GW operation that will make 24% efficient cells when completed in around two years. Shortly thereafter, SolarCity sees expanding operations to around 10 GW with options as to where that expansion takes place.

The drivers of this acquisition and the rapid expansion tells a lot about the solar industry as well as SolarCity's place in it. Elon Musk said on a conference call today that SolarCity is at "risk of not having solar panels we need," meaning costs could go up as demand begins exceeding supply. Since SolarCity "expects to be installing 10s of GW per year," according to Musk, the need to ensure capacity is great. 

SolarCity is also beholden to the technology suppliers can provide, something Musk isn't satisfied with. This will give SolarCity the opportunity to develop higher efficiencies in house. 

It takes money to build an empire
If SolarCity is going to be a big-time module manufacturer, it's going to need more capital. At the end of the first quarter, the company had $519.6 million in cash, money that it primarily uses to build projects before they're sold to tax equity partners and fund operations. With 105-110 MW expected to be built in the second quarter, and more in each subsequent quarter this year, that liquidity is needed to fund operations.

SolarCity wants to vertically integrate, including into batteries where its sister company Tesla Motors is planning a giga-factory. Source: SolarCity.

Management said the 1 GW solar plant will be built within two years, and $350-$400 million will be needed to buy equipment alone, so the total bill will probably be around $500 million. Management said, "This will be followed in subsequent years by one or more significantly larger plants at an order of magnitude greater annual production capacity."

So, by the end of the decade, we're talking about billions of dollars spent on manufacturing capacity if these plans come to fruition.

There's also the millions of dollars that now need to be spent on R&D to make the technology improvements SolarCity's management wants to develop. For perspective, SunPower spent $58.1 million on R&D last year, and First Solar spent $134.3 million. SolarCity didn't even call out an R&D line item in its income statement, so there will be a big increase in operating expenses.

Overall, this strategy will take billions of dollars to build out, meaning a likely huge increase in debt load as well as new equity offerings. Even if partners are brought in to help build out capacity, SolarCity will need more capital eventually. These funding needs are something investors should keep in mind. 

Why this is a good move for SolarCity
I don't think this is a move that comes without huge risks or the likelihood of dilution for shareholders, but strategically, it's the right move. Elon Musk alluded to the fact that demand for solar panels will likely exceed supply as early as next year, and that would lead to higher panel costs and lower margins and retained value per watt.

As SolarCity builds capacity it will likely grow in larger commercial projects like this one. Source: SolarCity.

Having captive supply of panels means SolarCity will be able to ensure its long-term cost structure up and down the supply chain. Keep in mind that this is a huge advantage if demand begins to exceed supply and panel prices go up, but it would be a disadvantage if there's an oversupply of panels, as we've seen in recent years. SolarCity is clearly betting on demand booming, something I think will happen as well.

Putting this move into perspective
The impact of buying Silevo for SolarCity is hard to quantify financially given the billions of dollars that will be needed to build out 10 GW or more in capacity and pay for research to stay ahead of the curve. Strategically, it's a good move, but financially, it will take time to tell if it's a success.

Many companies have failed as solar manufacturers, especially using new technology. So, while SolarCity has upside by making panels, it's also taking a huge risk both financially and on Silevo's technology.

As someone who has made SunPower his top solar pick for more than two years now, this gives major credence to SunPower's high efficiency, vertically integrated strategy, and the capacity it already has in operation. Remember that SunPower is already the industry's efficiency leader, and that won't change with this acquisition. It also has a history of making solar panels, something SolarCity doesn't have and is taking a huge risk on.

What we can take away from SolarCity's acquisition of Silevo is that vertical integration is the future of solar, and high efficiency will be key. The companies that can get those factors right will build projects for the lowest cost of energy, which will drive the solar boom into the future. SolarCity and SunPower are the two top stocks I would buy to take advantage of these trends.