When a new company like SolarCity (NASDAQ:SCTY) hits the market and catches momentum among investors it can seem like they can do no wrong. Elon Musk has guided the company to new heights and so far SolarCity's financial results have showed few flaws in the bullish logic.
But the solar industry doesn't stay in one place for long, and companies who are winning today can be pushed to the wayside quickly. Here are the three biggest risks investors need to be aware of when looking at SolarCity stock.
Transition away from leases
SolarCity has built value in its business through signing customers to long-term contracts that will pay a high rate of return on a solar installation. Management approximates the present value of those contracts minus the costs SolarCity incurs with a metric called retained value.
What's astounding is how fast retained value has grown recently. In the second quarter, retained value grew $513 million to $1.8 billion and each watt SolarCity signed up added $2.32 to retained value. That's an incredible margin based on an installed cost of $3.03 per watt.
But what if leases aren't the dominant paradigm in the future? Nearly every customer SolarCity has signed up in the past year -- particularly in residential -- has signed some sort of lease agreement, adding immense value to the company. But systems it sold for cash are far lower margin. For the first half of 2014, solar systems that were sold totaled $52.6 million in revenue but generated just a 4.2% gross margin. When operating costs are included it's likely SolarCity lost money on systems sales.
The risk is that consumers begin to understand and demand the tax benefits solar offers and push toward loans or cash sales. Currently, SolarCity keeps these benefits and monetizes them with tax equity investing partners. But if that paradigm changes, the $2.32 SolarCity generated in retained value last quarter may fall precipitously.
Customers don't live up to expectations
One thing we don't know about solar energy customers is how they will act long term. SolarCity is signing up hundreds of thousands of customers to solar leases and we don't know if they'll be reliable customers in 15 or 20 years or if they'll renew leases.
This could become a challenge for two reasons. First, SolarCity is assuming that all customers will renew leases at 95% of the rate customers are paying when the lease ends. This assumption is worth $558 million in retained value, or 31%, of the retained value SolarCity currently estimates. If that assumption doesn't hold true the value SolarCity generates from each customer will drop significantly.
The second question mark is whether or not customers will pay contracts as planned or default, remove installations, or demand restructuring before a lease ends. For example, I recently brought up the escalators in leases as a challenge long term because this could lead to solar actually being more expensive than grid energy over time. If there's no cost saving for having a solar system why keep it? SolarCity is moving away from escalators, so this risk may fall in the future, but for systems built so far escalators are a risk.
On top of the escalator, we don't know how a lease impacts the sale of a home. Early data points from Bloomberg and the Lawrence Berkeley National Laboratory indicate that owning a solar system adds around $25,000 to a home's value while a lease can actually lower the value of a home because you're asking a buyer to take on a new liability. This presents risk over the 20-plus years SolarCity is signing customers up for and leases are so new that we still haven't seen any real impact home sales will have on SolarCity because most of the installations are less than two years old.
The bottom line is that we don't know how solar lease customers will act over 20 or more years, and SolarCity's retained value assumptions are generous at best, so true value earned might be significantly lower than they're projecting.
Execution of Silevo
The third major risk for SolarCity is Silevo. This is the solar panel manufacturer SolarCity bought for $200 million, which could eventually grow to $350 million if production targets are hit. The company claims to be making 21% efficient cells and 18.3% efficient modules today with a target of 24% efficient cells and 21% efficient modules in the next few years.
What SolarCity plans to do is expand on Silevo's current plans and build a 1 GW manufacturing facility in New York with 10 GW or more planned long term. Depending on how partnerships go, the cost to build such facilities could be $500 million for the first 1 GW alone, so this is a big financial risk for SolarCity.
If SolarCity can't hit its two-year production plan it will have to buy modules from third-party suppliers, something that could be costly as Chinese solar tariffs hit and demand for panels worldwide grows.
There's also no guarantee SolarCity can scale the technology Silevo currently has in its pilot plant. SolarCity projects similar cost to current modules with higher efficiency, something that others have claimed and failed to execute before (think Solyndra).
Silevo may have been a risk SolarCity needed to take, but it's one investors can't ignore.
Foolish bottom line
SolarCity has a lot going for it, but investors need to keep in mind the risks associated with its business as well. Solar energy is a fast-changing industry and what's winning today may not be tomorrow, and SolarCity will have to adapt to those changes. There's no guarantee it can grow profitably and live up to a $6.6 billion market cap the market has given it.
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Travis Hoium has no position in any stocks mentioned. The Motley Fool recommends SolarCity. 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.