3 Problems With the Bear Thesis for SolarCity

The bear thesis for SolarCity (NASDAQ: SCTY  ) is no secret.

Bears have long had valuation problems with the stock. Specifically, many don't believe that the company should assume a 6% discount rate or a 90% renewal rate after 20 years for its retained value calculations. They believe the company should use a higher discount rate because a lot can happen during 20 years, including electricity prices falling on an annual basis or a higher than assumed percentage of homeowners defaulting on their solar lease/PPA contracts. They also believe that the actual renewal rate after 20 years will not be as high as 90% because SolarCity's customers will likely opt for lower cost panels at that time.  

The bears point out that if SolarCity uses a 10% discount rate and a 66% renewal rate after 20 years, the company's retained value would only be around half of what it is now.   

In addition to valuation problems, the bears believe that SolarCity will see more competition going forward as other companies enter, electric utilities fight back, and the U.S. government ratchets down its generous solar subsidies. 

The SolarCity optimists are undeterred, however. Here are three reasons why the bear thesis may only be relevant in a bear market:

Problems with the bear thesis
First, other solar companies such as SunEdison (NYSE: SUNE  ) , a company that Greenlight Capital owns, also assume a 6% discount rate for their retained value calculations. Even though there are some differences (SunEdison builds utility scale projects while SolarCity installs rooftop solar panels), the principle is that SolarCity is not alone in assuming the low discount rate.  

Second, SolarCity's stock price itself is an asset. In a lot of ways, SolarCity's market capitalization is like cash on a balance sheet. It works the same way when SolarCity acquires companies. If management does a good job acquiring and integrating companies, SolarCity can evolve into something different from what it is today. SolarCity can build its moat and increase its growth through a roll-up strategy.

Third, SolarCity has the ultimate competitive advantage in Elon Musk. As long as Elon Musk retains his Midas image and keeps his SolarCity shares, SolarCity's cost of capital will likely be lower than its rivals. And as long as Tesla is successful, SolarCity will likely have a leg up against its competitors in terms of battery storage and marketing.

The bottom line
When viewed through traditional value investor lenses, SolarCity's valuation doesn't make sense. The market is giving SolarCity a lot of credit for future growth and execution. If that growth does not materialize, or if the bull market ends and the market assigns SolarCity a higher cost of capital, the bears could very well be right in their thesis. 

But when viewed through growth investor lenses, SolarCity does represent an opportunity. Solar's levelized cost of electricity will only decrease as solar panels become cheaper and installers reduce soft costs. Even if retained value without subsidies/lenient assumptions is marginal today, it won't be marginal in the future. The total electricity generation market is a trillion dollar market, and SolarCity has competitive advantages.

Over the course of time, most overvalued stocks revert back to the mean. But some high-flying stocks just keep on outperforming. The difference between the ones that outperform and the ones that don't is execution. And execution is something SolarCity certainly does not lack. 

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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 June 27, 2014, at 8:47 PM, ronwiserinvestor wrote:

    Here's 3 problems with the Bull thesis:

    1.Pricing for solar has dropped to such low levels (less than $3.20 per watt or less than $11,000 for an average sized 4.75 kW system) that even when considering repair, insurance and monitoring costs, it no longer makes financial sense to lease a system.

    2. The $0 down solar loans that offer tax deductible interest that allow the homeowner to keep all of the incentives that are currently available, yield a far better return on investments for homeowners.

    3. GTM research the world's leading authority on the analysis of the state of the PV solar industry has in the past four days completed a study that concludes that the market for third party owned solar has peaked and will begin to decline.

  • Report this Comment On June 28, 2014, at 9:07 PM, BPAM wrote:

    Respectfully, SUNE and SCTY have an important difference: SUNE ground mounts. Ground doesn't deteriorate. Good shingle roofs last 25 years, cheap shingles last 15. If the mean remaining life in SCTY's portfolio is 12.5 years, the install has to self-amortize over remaining term to panel removal, e.g. leasehold improvement accounting. If SCTY used a 12.5 year self-amortizing duration on the note portfolio, the annual debt payments from the panel installs would require a price per solar kWh significantly in excess of current grid prices. The question of renewal rates at 20 year contract expiry is moot. If the roof leaks, the homeowner is incented to repair or replace the roof. Replacement will require removal of the panels (truck roll #1), a roofing company for a day or more and re-installation (truck roll #2). Installation labor is a significant component, up to a third, of the total installation cost. Here, we're talking about two truck rolls, labor for removal and labor for installation. If the noteholders aren't willing to pay for the removal and re-installation, and if SCTY isn't and the homeowner isn't, I expect the panels will be carefully, respectfully stacked in the homeowner's yard, and the default rates on SCTY pooled notes will rise. Just my opinion.

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