When Tesla Inc (NASDAQ:TSLA) bought SolarCity for $2.6 billion late in 2016, a lot of people (including myself) called the deal a bailout of Elon Musk's high-profile solar company. The deal didn't seem to do anything to advance Tesla's electric vehicle (EV) business, it will be a drain on cash, and it was a huge distraction given the business-model change and manufacturing expansion SolarCity had undertaken.
Fourth-quarter results from Tesla released after the market closed on Wednesday didn't do a lot to change the narrative that SolarCity and Tesla are still a strange fit together. In fact, it could be argued that Tesla is winding down some of SolarCity's business. Here's how to look at Tesla's solar results last quarter.
The shrinking solar ambitions of Tesla
SolarCity has been reducing its installation guidance for a year now, so it shouldn't be shocking that Tesla's results fell way short of expectations. At the start of 2016, SolarCity expected to install 1,250 MW of solar in 2016. By the end of the third quarter, the company had reduced guidance to 900 MW, implying about 300 MW of installations in the fourth quarter.
In reality, SolarCity and Tesla installed 201 MW in the fourth quarter and hit just 803 MW of installations for 2016. This is an incredibly disappointing result and the fourth quarter is traditionally a peak for the company as people try to get year-end tax incentives.
The move to sales from leases is good, right?
Tesla touted the $77 million in cash generated during the final six weeks of the year and the sale of 28% of solar systems, rather than capital-intensive leases. And on the surface both look good, but that may not be the case.
The cash generation includes tax equity funds being raised that will be lumpy from quarter to quarter, so it isn't as if you can extrapolate $77 million in cash generated during those six weeks into a cash flow projection for the year. In fact, management said on the conference call that SolarCity's leasing business would hopefully have no impact on its cash position this year.
What's more concerning is that the energy generation and storage line item on the income statement showed just $3.6 million in gross margin for the quarter to $131.4 million in revenue, or a 2.7% gross margin. By comparison, SolarCity generated a 35.7% gross margin for the third quarter of 2016. This could tell us that slow sales didn't offset higher costs, energy storage margins are low or negative, or that solar system sales are incredibly low margin. No matter what the cause, a margin that bad can't be good.
The move to sales will also come with more competition. A customer may be more likely to shop around to find the best price if Tesla is selling systems for cash, which will likely lead to lower margins.
Remember that SolarCity came with over $1 billion in run rate annual operating expenses, which have to be paid for with the gross profits from running the business. If profit margins are terrible, it could lead to the solar business being a cash sink for Tesla long-term.
Is SolarCity's installation arm in trouble?
Tesla is talking a lot about turning the solar business into a more sales-focused business and getting away from leases (more of a necessity than a choice, in reality). If Tesla is going to move to a more opportunistic sales model through its retail stores, it would make more sense to contract installation through local contractors that will be the boots on the ground, leaving Tesla to act as a sales and engineering company. This isn't uncommon, like when Home Depot or Lowe's sell a kitchen setup or Toll Brothers builds a house, they use local companies to do the actual work.
But that could entail Tesla laying off thousands of installers and salespeople who were once at the heart of the business. But it looks like that's what Tesla is setting up to do, and when you look at the $1 billion in operating costs, it's the thousands of workers that SolarCity had on the payroll that add a ton of risk to Tesla's operations.
Tesla hasn't made any announcements yet, but with the scaling back of solar ambitions and the move to start selling solar systems through Tesla stores, it would make sense to jettison the installation arm. And the slowdown in installations last quarter may be in anticipation of the change.
What is Tesla doing with solar manufacturing?
Musk and Co. talked a lot about solar manufacturing on Wednesday and dubbed the Buffalo solar plant Gigafactory 2. Time will tell if Tesla will be able to make solar panels cost-effectively, but even if it can, the low output and potential transition of installations might be a problem for the plant.
When the state of New York gave SolarCity a $750 million subsidy to build the Buffalo plant, it came with a requirement to "employ 1,460 high-tech jobs for the manufacturing operation" as well as "employ at least 2,000 other personnel in the State of New York to support downstream solar panel sales and installation for five years." This is on top of 1,440 support and contractor jobs that SolarCity was supposed to indirectly provide. Tesla may have a hard time hitting that commitment if it scales back on its installation fleet.
On a more fundamental level, Tesla's move into solar manufacturing is confusing and disappointing. I don't know why the company would want to be in the highly competitive solar manufacturing business, where dozens of companies have gone bankrupt. And the company's Silevo acquisition, which drove the move into manufacturing, happened in June of 2014, and we still haven't seen any sort of manufacturing at scale. There are promises that the second half of the year will see solar panels with Panasonic technology start rolling out along with the solar roof, but until we see product, spec sheets, and pricing, investors should be skeptical.
Tesla isn't making a big bet on solar
With all of these factors considered, it's safe to say that Tesla is scaling back SolarCity's solar growth ambitions and may even be shrinking the business altogether. And long-term, that might be the right move given the tough economics in residential solar.
Investors should keep an eye on the transition Tesla is making to more cash solar sales and solar at retail stores to see how strong the investment in solar really is -- and what the returns are. It may just be a bolt-on product made to make electric cars look cooler, which may not be the worst thing at the end of the day, all things considered.