Is SolarCity Corp Stock a Buy?

SolarCity workers install a rooftop solar power system. Source: SolarCity.

SolarCity Corp (SCTY.DL) has come to dominate the residential solar market and has built a $5 billion market cap along the way. But the stock has been stuck in a rut recently as growth figures have come in below lofty expectations and investors sell off all energy stocks because of the fall in the price of oil.

So, is this a buying opportunity for investors or a time for caution? In a lot of ways, it depends on how you look at SolarCity.

What SolarCity has built in solar leases

Thus far in its history, almost all of SolarCity's business has been built on the solar lease or power purchase agreement (PPA). Customers pay little or nothing down and agree to buy energy from a solar power system SolarCity installs on their rooftop for a set price over 20 years.

To approximate the value of that installation, SolarCity came up with a concept called retained value, which is the future cash flows of each project discounted at 6% to today's dollars. This is after operating costs like sales and administration, but it gives an idea of what the ongoing cash flows of the business should be.

As of the end of Q3 2014, the company had $1.54 billion in contracted retained value and $640 million in renewal retained value, which I will disregard because there's currently no evidence customers will re-sign a solar lease in 20 years.

What's impressive about the contracted retained value SolarCity has amassed is how it has grown compared to the cost of acquiring that value. Below, I've created a table that I like to use to assess value added each quarter. I calculated the change in contracted retained value and then subtracted operating expenses, because items like sales, general, and administrative costs are incurred today, while retained value is the future cash flows of a project.

Note: Q2 2014 includes value from securitization offering. Source: SolarCity.

This value added is an approximation for earnings before interest and taxes in present-day dollars. What you can see is that SolarCity is creating a lot of value above what it costs to sell solar systems. But this may soon change.

Moving to solar loans

One of the biggest strategic changes SolarCity has ever made is moving into solar loans through a product called MyPower. Unlike a standard loan, MyPower has payments calculated based on the energy produced by a homeowner's solar power system, not just a set payment. As the system produces power, the homeowner's solar loan is paid off, and the homeowner keeps the long-term cost benefits.

To me this is an important offering because I'm very skeptical of the long-term viability of solar leases and PPAs. As the cost of a solar power system gets cheaper, the payback time falls, making owning the system more attractive. Add to that the end of the investment tax credit in 2017, and there will be less need for tax equity investors to realize the tax advantages of a solar power system. This will make leases harder to sell in five or 10 years.

I think long-term, the solar market will look more like car financing, where leases are an offering but they're only about 20% of the market compared to 80% for loans and cash sales.

The advantage of the loan model for investors is that instead of basing SolarCity's valuation on 20-year contracts that may or may not perform as expected, a loan will be a sale, hitting the income statement immediately. This means gross margin today instead of a retained value estimate made for the future.

Initially, management expects to be selling systems for $4.35 to $5.60 per watt compared to $2.90 per watt in cost for SolarCity. That's a lofty 33.3% to 48% operating margin if those prices can be maintained.

Long term, that kind of margin will be nearly impossible to maintain, because competitors will swoop in with lower prices (something we're already seeing), but even if SolarCity can generate a 10% to 20% operating margin, it'll be a positive for investors.

But even if value is added, whether it's operating margin or retained value after operating costs, it will likely settle between $0.25 and $0.75 per watt. At the midpoint, that's $500 million of value added for every 1 GW installed annually.

More communities like this are going solar. Source: SolarCity. 

SolarCity is a great buy if you have a long time horizon

Calculating SolarCity's value is really a guessing game, but let's give it a shot.

If SolarCity can grow beyond 1 GW, which I think will be easy for it to do, it could be a great value for investors. I don't think installing 10 GW per year is out of the question within the next decade, and at that point, SolarCity should be a much larger company from a market cap perspective.

Even at $0.25 per watt in value, 10 GW would equate to $2.5 billion in annual value add. A 10-times multiple and a $25 billion market cap wouldn't be out of the question at that point, meaning SolarCity would be five times bigger than it is today.

Long term, investors could do very well with SolarCity, and I would be comfortable owning the stock, but keep in mind it will be a bumpy ride. SolarCity has to ride out the investment tax credit expiring in 2017, and new competitors are getting more aggressive every day. This will impact the stock in the short term, but as long as SolarCity can cut costs and continue to innovate its business model, I think investors will have a winner with this solar industry leader.