Holes Forming in SolarCity's Massive Valuation

Finally, SolarCity's (SCTY.DL) fourth-quarter 2014 numbers are out and by the look of the market's reaction, investors aren't terribly happy. Quarterly revenue was $47.3 million, loss from operations rose from $32.3 million a year ago to $55.3 million, and non-GAAP loss per share was $0.46.

But the bigger focus today is on the expected first-quarter loss of $0.70 to $0.80 per share, which is well below the $0.53 analysts expected the company to lose. We're also getting some hints that customers are shifting to cash sales, which don't generate the same value for SolarCity. So, let's dive into the trends we're seeing and what investors should be looking for going forward.

A solar installation on a Wal-Mart distribution center, completed by SolarCity. Commercial installations like this one accounted for a higher percentage of revenue than normal in the fourth quarter. Image courtesy of SolarCity. 

Cash sales are picking up
Not every solar installer looks at their sales channels the same way and that's one of the major differentiators among competitors SolarCity, SunPower (SPWR -8.41%), and RGS Energy (NASDAQ: RGSE). SolarCity has explicitly stated that it wants to own leased systems and actually ran a negative 4% gross margin last quarter on systems that it sold for cash.

SolarCity workers installing a rooftop system. Image courtesy of SolarCity.

SunPower and RGS Energy, on the other hand, offer leases, loans, and cash sales to customers and don't care which one they choose. SunPower sold about 70% of its residential systems for cash last quarter (although it doesn't break out margins) and RGS Energy generated a 21% gross margin from system sales and selling leases to third-party owners.

Since SolarCity is focused on leases and runs a loss on system sales, it would be concerning to see sales pick up and lease mix drop. But that's exactly what we've seen recently.

One way to see the shift is in solar system sales trends versus MW installed. System sales were higher than expected in the fourth quarter, which set off alarm bells for me in late February, and guidance for Q1 2014 reinforced the trend. You can see that even though installations will fall quarter over quarter, system sales will remain about flat, meaning they're expected to be a higher percentage of the mix.

Source: SolarCity earnings releases.

This can also be seen in retained value added each quarter versus MW booked. When SolarCity books a customer to a lease it adds the projected retained value of future cash flows to its reported retained value calculation. Conversely, a cash sale doesn't have a retained value number because it immediately hits the income statement.

So, it's interesting that retained value added in Q4 was down sequentially even though MW booked was up, indicating that booked cash sales are a higher percentage of the company's sales mix.

Source: SolarCity earnings releases. Note: Q4 2014 retained value figures have pulled out $60 million in value for the completed securitization deal, per management's comments.

These numbers don't guarantee that cash sales will be a growing part of SolarCity's mix long term but it's definitely something to keep an eye on. 

Why this is a big deal to SolarCity
Selling more systems for cash isn't inherently bad and won't result in weak installation figures, but it could dramatically change the amount of value SolarCity generates for shareholders. In the most recent quarter, management said it projected $1.90 per watt in retained value for the quarter, which implies a nearly 40% retained value margin if we assume installations cost around $3 per watt.

The moves into securitization and solar financing products for individuals could also hold less value if more systems are sold. After all, $60 million in additional value was generated from the just one securitization deal completed last year.

Residential solar community with SunPower panels. Image courtesy of SunPower.

What's good for homeowners?
The question is which way the market will move long term? I think cash or loan sales will become ever more common in the future, particularly as costs fall. If a consumer buys a system, he can keep the tax benefits as well as all of the cost savings from going solar. As solar loans become more prevalent, we'll see rates fall to somewhere near SolarCity's securitization deal, meaning homeowners will be able to take advantage of solar financing without giving ownership out to someone else.

I also think we'll see installers compete on cost of installation as the number of installers grow, which will cut margins. It's far easier to compare two cash offers from installers than a 20-year lease to a fixed cost to install a system, which may be the case today. Since SolarCity has better infrastructure in financing, it can offer better rates on leases, expanding margins, but won't have the same advantage competing for cash sales.

Reasons to be cautious about SolarCity's stock
That's why I see SunPower, which makes the industry's most efficient panels and sells through partners, and RGS Energy, which offers a suite of sale options, as better values in the current marketplace. With a $6 billion valuation, SolarCity is priced as if it will generate $2 in value from installations for years to come, but I think that number will fall, particularly as cash sales increase. 

If the shift away from leases does happen, SunPower and RGS Energy will be better able to compete and offer more upside for investors with $4 billion and $200 million market caps, respectively.

SunPower is already profitable, RGS Energy expects to be EBITDA positive in Q4, and SolarCity is still losing money quarter after quarter and can't generate positive margins on cash sales today. You'd have to assume leases continue to grow and margins remain high to think SolarCity is a value today and that's not the way I think the market is headed.