SolarCity (SCTY +0.00%) is up by more than 535% since its IPO. Given that the company is still reporting losses, it's easy to think that its stock is expensive. However, there are some unique challenges to understanding what SolarCity is worth. Here are two issues to consider before attempting to value the stock.
Rise of the lease arrangements
In the past, going solar wasn't practical for many consumers due to the high costs of installing solar systems. In 2008, SolarCity introduced an option for customers to "go solar" with little to no upfront costs.
This is done with lease and power agreement arrangements where customers pay monthly fees for the systems and power instead of buying equipment outright. According to Standard & Poor's, about 60% of SolarCity's revenue will come from these arrangements by 2015.
Many of SolarCity's competitors offer similar arrangements. For example, SunPower (SPWR +0.00%) started to offer lease arrangements in 2011. SunPower has a market cap of $3.6 billion and $2.5 billion in annual sales. Real Goods Solar (NASDAQ: RSOL) is another example. The company has a market cap of about $96 million and annual sales of about $98 million.
Issue #1: earnings versus reality
Consumers seem to like the arrangements. According to SolarCity's most recent 10Q filing, over 90% of third-quarter solar system sales were done through lease agreements. The issue with these arrangements is that they're actually very complex. Here's an example of how the agreements are often structured at SolarCity.
- SolarCity creates a "financing fund" into which investors contribute money.
- The fund uses the money to buy solar power systems from SolarCity -- this generates cash and revenue for the company.
- The fund leases the equipment to customers and receives monthly payments from those customers.
- The fund allocates to investors (that can include SolarCity itself) their respective shares of customer payments over time.
- Repeat.
To top it off, established accounting standards handle these arrangements with special treatment. For example, while SolarCity may receive an upfront payment of $30,000 from a financing fund, that payment may be recorded as incremental revenue over time. In other words, it could be recorded as $1,000 in revenue per year for 30 years (to replicate a lease).
| Year | 2009 | 2010 | 2011 | 2012 | TTM |
| Net Income | -26 | -39 | 44 | -64 | -55 |
| Cash Flow | 2 | -4 | 18 | 60 | 248 |
Source: Morningstar, BCM
Issue #2: monetization of tax benefits
The government offers various tax credits and incentives tied to the purchase and use of solar power. SolarCity is able to monetize these tax benefits by selling them to its financing funds for cash and recognizing the proceeds as revenue.
In other words, SolarCity makes money from what are basically government tax subsidies. The subsidies make it possible for SolarCity to offer no-upfront-cost solar systems with monthly payments that are less than those of incumbent electric power providers.
However, the tax benefits won't be around forever, and that's clearly an impending problem. SolarCity's management recognizes this as a significant risk. Consider the following statement from the company's most recent 10Q:
Reductions in, or eliminations or expirations of, governmental incentives could adversely impact our results of operations and ability to compete in our industry by increasing our cost of capital, causing us to increase the prices of our energy and solar energy systems, and reducing the size of our addressable market. In addition, this would adversely impact our ability to attract investment partners and to form new financing funds and our ability to offer attractive financing to prospective customers.
Ultimately, this variable is tied to unpredictable legislation. How do you price that risk into valuation? What's the "discount rate" for uncertain government policy? It's complicated and subjective to say the least. In SolarCity's case, it is also something that must be considered.
The bottom line
As with any investment, I think it's crucial to have a clear understanding of how a company generates profits, not just today but also into the future. Without that, it's hard to determine fair value for the stock.
This is all easier said than done for SolarCity, where revenue and earnings are complicated by a mix of funds, investors, taxes, and accounting quirks. At the very least, I'd want to know how SolarCity plans to attain profitability without government subsidies.
That being said, this isn't a recommendation for or against SolarCity. I'm just pointing out that SolarCity is more complicated than it may seem. Those considering an investment in SolarCity should look beyond the headlines and reported numbers to develop a genuine understanding of the business and its long-term prospects.
