SolarCity (NASDAQ:SCTY.DL) is a contentious stock. The bulls hail SolarCity as a distributed power 'killer app' that will disrupt the power grid. The bears think SolarCity is nothing but a tax payer supported scheme. One in five SolarCity shares are short but the stock is up 340% year to date. Which side is right?
The bear thesis
The crux of the short thesis is that SolarCity is not profitable nor will be in the foreseeable future.
Bears argue that SolarCity has strong growth now only because of the current 30% investment tax credit that is scheduled to drop to 10% come Jan. 31, 2016.
Bears also note that most states limit net metering, which allows property owners to sell the energy they don't use back to their local utility at above-market rates. According to some estimates, utility customers in California, SolarCity's largest market, could reach the limit by next year.
Lastly, bears point to SolarCity's assumed discount rate of 6% versus the standard 10% in its net present value assumptions. They argue that SolarCity has not been around long enough to use such a low discount rate, and using the standard discount rate gives a much lower valuation than the current market price.
Three reasons to be more optimistic
That being said, there are some reasons to be more optimistic about SolarCity.
First, in runaway bull markets, story stocks trade on perceived potential rather than current fundamentals. There is no doubt that SolarCity is a great story stock. It is the market leader in a sector that has the potential to disrupt the large electric utility market. It has the modern day Thomas Edison in Elon Musk as chairman. It also has astounding growth. In terms of megawatts deployed, SolarCity had 109% growth overall and 151% growth in the residential segment for Q3 versus last year.
The second reason to be optimistic is that SolarCity is in a positive feedback loop where a high stock price will allow it to grow faster. With a high stock price, SolarCity can issue shares to raise money as it did in the October secondary offering or use its stock to buy companies such as Paramount Solar to increase its growth. In a market that only judges SolarCity on its growth numbers, higher growth leads to a higher stock price, and the positive cycle continues.
The third reason to be optimistic is that insiders are not selling their shares. Of all market participants, insiders have the most information because they are the ones actually operating the company. Rather than selling shares, insiders have actually been buying. Chairman Elon Musk purchased over 200,000 shares and CEO Lyndon Rive purchased over 100,000 shares in SolarCity's most recent secondary offering at $46.54 a share.
The bottom line
It is dangerous to short a stock in a bull market without a near-term catalyst. Right now the market is focused only on growth metrics, and SolarCity is delivering.
Although growth will likely slow as tax incentives are reduced, falling solar costs will eventually make the rooftop solar companies profitable. As an example of falling costs, SolarCity's operational costs/watt has come down over the past quarter from $0.80/watt in Q2 to $0.59/watt and looks poised to continue.
I believe that the two market leaders in the distributed power market, SolarCity and SunPower (NASDAQ:SPWR) are both great investments. Both enjoy critical support from big institutions such as Goldman Sachs and Total and have access to cheap capital to grow further. The positive feedback loops that have powered their share advances can continue for an extended period of time. I would avoid a small companies like Real Good Solar that do not have access to cheap capital and cannot participate in the positive reflexive loop. Those sector laggards may struggle if they are not acquired.
Jay Yao 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.