This article is part of our Real-Money Stock Pick series.
Late last week, an article was published on Seeking Alpha that claimed SolarCity (NASDAQ:SCTY.DL) was "egregiously overvalued." On the surface, it appeared to be not much more than a short article bashing the solar-panel installation company.
Because I own shares both personally and in the Messed-Up Expectations portfolio I run for The Motley Fool, I wanted to see what CDM Capital, the author, had to say. And, somewhat to my surprise given my past experience with articles written from the short perspective, CDM raised some good points, ones I've raised myself. On the other hand, it also has some assumptions that I'm not sure I agree with.
Author is short
It's good that this is disclosed. Readers of CDM's piece should take the bias that raises into account when reading the article. And readers should also take into account that I own the shares, as I stated.
Investment banking and ratings
CDM points out that many (if not all) of the analysts with favorable ratings on SolarCity are employed by banks that have an investment-banking relationship with the company. This is indeed a concern and a possible source of conflict of interest. I haven't read the reports by the various sell-side analysts, but ideally they should include disclosure that the firms they work for have an investment-banking relationship if that's indeed the case.
Discount rate/cost of capital
In presenting the metric "Retained Value" (RV, the present value of the cash flows to SolarCity from the leases its customers sign less certain expenses), SolarCity uses a fairly low 6% rate to discount those future cash flows back to the present.
This is a legitimate issue. I believe a better discount rate is the firm's cost of capital. That's WACC, the weighted average cost of capital, a combination of the cost of debt and of equity. (There might be legitimate reasons SolarCity uses 6%, but I haven't read them yet.)
Cost of debt is straightforward: the after-tax interest on debt. I haven't done a lot of digging, so I don't know for sure if SolarCity discloses this, but it could indeed be 6%.
Cost of equity is much harder to determine, and the best one can do is estimate it. One way is by adding the risk free rate to the product of the company's risk premium and the stock's beta. (That's the Capital Asset Pricing Model way, which has some assumption problems of its own, but is commonly used because it can actually be calculated.) Risk-free rate is the Treasury rate for the period of investment, currently 2.75% for a 10-year note. The risk premium is how much extra an investor requires to choose to invest in the company rather than the Treasury and, historically, has averaged between 3% and 7% or so. Beta, of course, is how much the stock's price moves relative to moves in some comparable index, usually the S&P 500. Cost of equity is always going to be higher than cost of debt.
Estimating cost of capital
According to S&P Capital IQ using the latest balance sheet (9/30/13), capital = $316.4 million debt (including capital leases) + $306.1 million equity = $622.5 million. Beta is 5.66 according to Yahoo! Finance, but this is probably a monthly-based number. SolarCity has only been trading for a year and it's easily calculated, so if I use weekly Friday closes, then beta vs. the S&P 500 is 3.68.
It's a fairly risky company, so let's give it a risk premium of 7%.
Cost of equity, Ke, then, is 2.75% + (3.68)(7%) = 28.51%
Let's assume cost of debt, Kd, is equal to what the company is using for its retained value calculation, 6%. Let's further assume that it will eventually pay 35% in taxes. Here, then, is the calculation for WACC:
WACC = (debt/capital)(Kd)(1-0.35) + (equity/capital)(Ke) = (316.4/622.5)(6%)(1-0.35) + (306.1/622.5)(28.5%) = 16%
For a company that's perceived to be as risky as SolarCity, that's not an unreasonable WACC.
The best handle we have on the value of the company comes from the RV. The company uses 6% to calculate that, while I believe 16% is probably more appropriate. CDM Capital says 9% is appropriate, though I missed any discussion as to why.
To see why the discount rate is so important, let's look at the present value of an annuity, which is an unending stream of regular cash flows. The present value is the annual cash flow divided by the discount rate. If the cash flow is $1,000 per year, using a discount rate of 6% means PV = $16,667. Use 9% and PV = $11,111. Use 16% and PV = $6,250, some 63% lower than the 6% PV level. It's really important that an appropriate discount rate be used.
If 16% is a reasonable WACC, why did CDM Capital use 9% instead? To be fair and optimistic as it wrote but still penalize the company? I feel if you're going to change a discount rate, use one that you think is fair, not one based upon a statement like "the cost of capital we believe is actually north of 10%; a discount rate of 9% seems quite optimistic."
Setting that aside, what I'd really like from SolarCity is an explanation of why it uses 6% when calculating retained value, so that I can judge the reasonableness of the rate.
Failing that, I'd be more comfortable if the company discounted at a higher rate than 6%. That it doesn't is one of the dings against it. But unless I build a model of projected annual cash flows, for which I believe not enough information is available to make this nothing more than a wild guess, I cannot actually use my higher 16% discount rate at this time.
Back to the point: All else equal, a lower discount rate makes the calculated present value higher than when calculated with a higher discount rate, as you saw earlier. I agree with CDM Capital's point that the discount rate used for RV is almost certainly too low, but to use a higher rate (e.g., the 9% CDM Capital suggests), one needs to know the annual cash flows for the period modeled, and SolarCity doesn't disclose those, as far as I know.
Instead, in my valuation model, I approached this in a different way, by underestimating how many MW of power the company is likely to install. Let the company use its inflationary 6% discount rate; just give it less to inflate.
100% renewal assumption
This is another good point raised by CDM Capital. The original leases between SolarCity and its customers are 20 years long. In calculating RV, SolarCity pretty aggressively assumes 100% of those customers will renew for an additional 10 years (when all the cash flow belongs to the company). That's another ding against the company.
I addressed this the same way CDM Capital did, by cutting way back on that 100%. CDM cut to 50%; I went further and dropped it down to 33%.
Price to sales
CDM Capital uses a fair amount of digital ink focusing on this metric and compares SolarCity to several other recent technology IPOs. I think that's a mistake. SolarCity reports basically squat for sales because it isn't selling the equipment -- it's leasing it. It's not reporting a lot of lease revenue yet, because it's still early in its growth trajectory. As a result, price-to-sales is inflated. Looking at gross margins today suffers from the same issue: It's an early stage lease model that's growing very quickly. The market seems to be pricing the company on its perceived ability to grow the number of leases for the next several years.
The federal government is investigating SolarCity to see if it overstated the value of its installations to claim a higher tax benefit. This is a known issue. Implying a causal link between that investigation and lower gross margins, as CDM Capital does, is, in my opinion, spurious. Further, criticizing the company for not more vigorously defending itself against Barron's reporting ignores the fact that it's stupid for a company to comment publicly on an ongoing investigation. Anything it says can probably be fed into the investigation, so it's prudent to stay silent.
CDM raises some good points about the company, ones that I've tried to address in my rough valuation of it. Today, my model says that SolarCity is trading for roughly 1.75 times projected 2017 RV of $3.3 billion. Compared with the most recent RV, SolarCity is trading about 6.9 times, quite a bit higher than when I bought it for the MUE portfolio.
Does that make SolarCity overvalued today? Possibly. It really depends on how many MW of solar power it can install over the next several years and how many of its customers renew for an additional 10-year lease at the end of their current contracts, both items that my model attempts to underestimate. However, unlike CDM Capital, I don't believe that SolarCity is "egregiously overvalued."