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Is SolarCity Really the Next Subprime Disaster?

By Travis Hoium - Sep 21, 2015 at 3:05PM

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Short seller Jim Chanos thinks SolarCity is a financial disaster waiting to happen. Does he have a point?

Image: SolarCity.

Well-known short seller Jim Chanos has mounted a full scale assault on SolarCity's (SCTY.DL) business in recent weeks, calling it a "subprime finance company."  

Not surprisingly, SolarCity's Lyndon Rive questioned his understanding of the business and pointed out that it's a risky time to be shorting such a high-growth stock that's already down significantly over the past year.

Who is right, and what should investors take from this brewing battle? 

SolarCity's growing commercial business could mitigate some of the risks Chanos is afraid of. Image: SolarCity.

Is SolarCity subprime? 
The first thing to understand is that having Chanos invoke the word "subprime" is a bit disingenuous. SolarCity's securitizations are repeatedly backed by customers with FICO scores averaging over 760, making them highly qualified borrowers. So it isn't as if these are borrowers getting in over their heads on an asset they can't afford.  

Comparing an energy product with a mortgage is also an apples-to-oranges comparison. What SolarCity is really selling is energy, and as long as it's selling energy for less than the utility, its customers have an incentive to continue paying. It's not like they're just going to turn the lights off and default on obligations to SolarCity to pay higher rates to utilities.

But Chanos does have a point that SolarCity is financing a product that has a lot more unknowns than a lot of investors think.

SolarCity may have risks investors don't understand
So far in its time as a public company, SolarCity has gotten the benefit of the doubt from investors. The company reports quarter after quarter of losses with the promise that a payoff will come someday. It certainly could, but there are risks to a business model that relies on 20 or 30 years of contract payments. That's what Chanos is keyed into, and he has some valid points.

Here are the four risks that I think investors need to know and understand in SolarCity. Depending on how you look at them, they could be reasons to avoid the stock entirely, or they could simply be unknowns that are part of doing business in a new market like residential solar.

  • SolarCity's default rate in 2014 was 0.6%. That sounds low, but at a compounded rate over 20 years that can lead to a pretty large chunk of customers. And it makes sense that default rates will only rise over time. As homes turn over, new customers may not have as attractive of credit profiles as current customers, and it's logical that defaults will rise as time goes on and the new energy savings SolarCity is promising moves further into the rearview mirror (driven by factors I'll discuss in a moment). If defaults are higher than expected, then Chanos' subprime analogy could prove correct.
  • There's no data showing if future third-party homebuyers will want to take over a solar lease or PPA on aging solar panels. SolarCity assumes these buyers will gladly take on the current homeowner's obligation, but that assumption could be overly optimistic.
  • There's no data to support the thesis that homeowners will renew leases or PPAs after the 20-year initial term. SolarCity's published retained value figures assume that 90% of homeowners will renew at their previous energy rate. Of the company's $3.92 billion in retained value, $941 million is built on this assumption.If that's wrong, it could change the value SolarCity creates for shareholders.
  • A large percentage of SolarCity's leases and PPAs come with energy-price escalators, which assume that electricity costs will rise consistently in the future at a rate as high as 3.9% annually. In reality, price growth has slowed recently and nationwide retail electricity rates only averaged 1.7% growth between 2008 and 2013 (the most recent data available). If SolarCity's rates increase faster than utility rates, it could eliminate the cost benefit of solar and lead to defaults or contract renegotiations.  

When you add these risks together, or even compound them on top of each other in some cases, it's easy to make a bear thesis for SolarCity. Investors need to understand what the company is selling when it reports things such as contracted payments and retained value, which may or may not be good measures of value going forward. 

But I don't think that risks in the solar industry can really be compared to subprime mortgages. Yes, a lease is a liability, but it also adds value to homeowners and offsets energy costs that anyone living in a home would have to incur. So there are risks, but this isn't the subprime crisis all over again. 

Chanos is making a high-risk bet against solar energy
While I understand some of the challenges for SolarCity, I also think investors thinking about shorting the stock need to understand that betting against solar energy is a high-risk bet. Solar energy is now lower-cost than electricity from the utility in many states, and even a reduction in the investment tax credit, or ITC, won't derail a company like SolarCity.

Given the funding structure SolarCity has, there's also very little risk on a project basis. A system is essentially financed in the first year after construction, and the payments it receives over 20 years are largely profit for SolarCity. That could change as the ITC changes, but as long as SolarCity keeps signing up customers, it'll be able to stay afloat.

But the biggest reason not to short SolarCity is that the company has learned how to adapt to survive and thrive in the solar industry. One example is the transition it's making toward loans right now. We don't know what the industry will look like in 10 years, but I'd be willing to bet that SolarCity will find a way to be a major player, and that should scare the heck out of short sellers.

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