SolarCity blamed commercial projects like this one for falling margins. Image source: SolarCity.

The residential solar industry continues to grow at a rapid rate, and there's no question that SolarCity (NASDAQ:SCTY.DL) is the industry's leader with a 39% market share. What is in question is whether the company will ever be able to make a solid financial return from the systems it's installing around the country.

In the fourth quarter, the company reported a 52% increase in revenue to $71.8 million, but net loss on a non-GAAP basis was $141.4 million, or $1.47 per share, $0.20 worse than expectations. Before getting into what went wrong at SolarCity, let's look at some good news.

Image source: SolarCity.

SolarCity, the growth machine
New customers in the fourth quarter signed contracts for 206 MW, more than double a year ago, and installations grew 70% to 176 MW. The MyPower loan product launched in the fourth quarter accounted for about 30% of residential sales and was so successful that management raised interest rates from a range of 4.5-5.0% to a range of 5.0-5.5%.

Retained value, SolarCity's preferred method for valuation, also increased by $409 million in the quarter, highlighted by $3.56 per watt in retained value in the MyPower product.  

Cost per watt also fell to $2.87, although that was only a small decrease from $2.90 per watt in Q3.

What went wrong for SolarCity
In my earnings preview article, the first thing I said investors need to look at is the rate of solar installation growth. During the third-quarter conference call, management said the company will install 179 to 194 MW in Q4. As I mentioned, installations came in lower than that, at 176 MW.

This is a huge deal, because it's the second straight quarter SolarCity has missed installation guidance and calls into question the company's long-term growth plans. Management gave similar excuses as last quarter, saying that commercial installations were slower than expected, but notice that 2015 guidance of 920 MW to 1 GW of installations didn't go up despite this quarter's miss.  

Image source: SolarCity.

The other surprising, and concerning, figure is a negative 17% gross margin on systems it sold during the quarter. This is key, because as solar loans and cash sales become more prevalent in the industry, SolarCity will have to compete on price with companies such as SunPower (NASDAQ:SPWR), which sells around 70% of the systems it builds. If it's selling systems at a negative margin, that's bad news for future operations.

Finally, operating expenses exploded 107% higher in the fourth quarter to $134.9 million. These are costs that aren't included in the retained value calculation, such as sales and administration costs, and they're immediate costs, so it's important to keep these low. But they're growing faster than installations, as SolarCity is trying to grow its footprint.

SolarCity faces many questions going forward
The reality is that SolarCity is finding it harder than expected to meet its growth goals and has spent far more money than it hoped to expand operations. The result is mounting losses and a reliance on an ever-expanding financing pool to fund operations and growth.

I also question SolarCity's very generous assumptions in retained value, which assumes homeowners will pay lease and loan payments consistently over decades, even as a home passes from one owner to the next. I think that proposition becomes harder as costs fall and solar technology improves. After all, why would I want to buy a home and take on a 10-year lease with 10-year-old solar technology?

In the coming days I'll be back to break down this earnings report further, but the early look of disappointing installations and growing losses shouldn't sit well with investors. So it should be no surprise that shares have fallen about 4% after hours.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.