SolarCity is at a $2bn valuation! What a success story for IPO investors and for the solar industry as a whole. The effects are already felt throughout the industry. Given the way SolarCity’s CEO pitches the company (We are a next generation energy company.), the interest in financing and owning the long-term contract is increasing.  This should open financing options to consumers and is a welcomed relief after the expiration of the cash grant created a tax equity bottleneck.

Now, let’s look at this as a public market investor. Is $2bn a fair valuation for SCTY? Given that GAAP makes a mess of SolarCity’s financials and really doesn't help much in understanding its business, Wall Street seems to completely ignore traditional financial metrics. An interesting metric that Lyndon Rive used in the last earnings call was net present value per watt installed, which is currently at $1.12/W. So a rough, back-of-the-envelope calculation would be to estimate the expected growth that Wall Street prices into SCTY given this NPV/kW number: $2bn / $1.12 per watt = 1,785MW which is equivalent to 300,000 residential systems. Since they are currently at 35k-40k residential lease customers, that’s a lot of (undiluted) growth already priced in. Clearly this simple calculation does not take into account all the complexities of valuing a business like SolarCity but it’s at least a starting point. Let’s see how it all plays out.

I highly recommend this article to anyone who is interested in understanding tax equity for the residential solar industry. It's a complicated issue but Josh Lutton at Woodlawn Associates found a way to summarize the key issues in an easy-to-follow fashion.

http://www.woodlawnassociates.com/tax-equity-101/

We are near the finish line for SolarCity's IPO. Since my last post, the company released their price guidance of $13-15 per share. At roughly 10M shares offered this means a decrease of the target capital raise from $200M to $150M. At a $1BN market cap with stable post-IPO gains, this could still be a successful solar IPO. Within that target range, SolarCity would be the second most valuable solar stock (after First Solar). 

So how should a public market investor think about valuing SolarCity? The drop in hardware prices has been helping the downstream solar market. However, that doesn’t mean that SolarCity is sheltered from intense competition we’ve seen in other parts of the value chain. (There are plenty of companies competing with SolarCity in each of its verticals.) I think there are three relevant components to hone in on to arrive at a reasonable valuation: (1) the NPV of the future cash-flows of their lease contracts (net of selling, building, financing and O&M costs), (2) expected growth rates of new lease contracts, and (3) regulatory risk factors.

Before dissecting each of these, a few quick thoughts on why other things don’t matter. Firstly, being “fully integrated” is not worth much in itself except maybe the brand value of having big green trucks drive around which could help with customer acquisition and therefore positively impact (1) and (2). However, the fixed cost of carrying that sort of infrastructure is scary. Any significant decrease in sales would mean idle resources with adverse financial effects. Secondly, parallels to Tesla (just because Elon Musk is involved in both) are overemphasized in the press. Maybe you can infer a certain aggressiveness on how much risk the company is willing to take. Thirdly, using Real Goods Solar as a comp (the other publicly traded residential solar company) is pointless. RSOL does not offer their own financing which is where all the juice is for SolarCity. There are no solar industry comps for SolarCity. If you are looking for comps, looking at consumer finance companies would be more helpful.

(1) NPV of Lease Contracts

Without the long-term cash-flows of its leases, SolarCity would probably be valued at a fraction of $1BN, especially in the light of the struggling solar stocks everywhere. But investors love the certainty of long-term contracts. During their road show, SolarCity stated that the NPV of an average lease contract is $15k, which struck me as high when I first saw it. But digging into the assumptions, it became clearer how they have arrived at that number.

They assume a low discount rate of 6%. Given the lack of default history, nobody truly knows what a reasonable discount rate is. And by "default" I don’t just mean customers defaulting on their payments. Investors have to take into account the impact of non-performing assets since that risk is largely on SolarCity (panels with worthless warranties from bankrupt solar companies, trees overgrowing that nobody wants to cut down, settlements for mis-selling, problems around transferability when a house is sold, etc.). Therefore, I would be more comfortable with a discount rate of 8-9%. This would have a very material impact on the NPV (as it reduces it to $9-11k).

The other aggressive assumption in the calculation is the terminal value of the asset after the 20 year contract runs out (they call it “Renewal Option”). In their road show slides, SolarCity assumes over $17k of future cash-flows (at “year 20” dollars) which discounted back to today is $5k. Since the customer can (among other options) ask the system to be removed at SolarCity’s cost, some systems might have negative value to Solarcity. And if there is perfect information, the customer knows that they have a very strong negotiation position to bargain for a lower rate. But again, nobody really knows what will happen after 20 years. If I had to pick a number, it would be closer to $1-2k in PV. Taking these two together, the NPV of an average customer would be about half of the $15k.

The other big uncertainty is the true cost of customer acquisition. Everything below the gross margin line in the P&L is a big mystery. They claim the majority of those costs are investments in future growth. It’s hard to tell with the disclosures given.

(2) Future Growth

Currently SolarCity is sitting on roughly 35,000 leases. At $15k NPV, that would equal $500M in enterprise value. At $9k, it’s $315M of EV. Factoring in future growth, you can see how SolarCity and its underwriters came up with $13-$15 per share (or was it the other way around?). I think it’s realistic that the company can add 2-3x of new contracts over the next few years. However, can they do so at a reasonable customer acquisition cost? And how much more capital will be required? The company is swallowing up a lot of capital and additional capital can lead to significant dilution to equity holders (or levering up of the balance sheet). SolarCity’s brand is the big x-factor to its growth strategy. On the one hand, brands can be very powerful to fuel growth and create shareholder value. However, brands are very expensive to build and continuous investment is necessary. It’s hard to think of a residential installed product with a branded construction experience. ADT, the home alarm business, might be an analog but customers value ADT’s brand because of trust that it will protect them. I don’t know of any big residential roofing or electrician brands.

(3) Regulatory Risk
Any company that heavily relies on government subsidies is exposed to regulatory risk. Additionally, any business in the energy industry has to live with changes in the regulatory environment. Below I’m highlighting the key risks to SolarCity:

• All US renewable energy businesses rely on the 30% ITC (or cash grant before its expiration) and the depreciation tax benefit. With the re-election of President Obama, I don’t think there is significant risk for an early reduction in the ITC. However, depreciation rules might change and solar assets might not enjoy accelerated depreciation going forward.
  
• In line with the first point, rules concerning tax equity are very complicated and a key factor in figuring out how to value the tax benefit is determining the appropriate tax basis of the asset. The treasury thinks SolarCity was too aggressive on this issue and is investigating.
• Local incentives are another source of regulatory risk and uncertainty. Local markets can dry up overnight for solar developers as incentives disappear or SREC markets plummet (as happened in New Jersey).
• Another significant risk is the brewing conflict with utility companies. As the adoption of solar increases, utilities will feel the pain of losing revenues from some of their best (=high paying) customers. The utilities in California have already fired the first salvo in the battle. They will try to change rate structures that will make solar customers pay their “fair share” for the maintenance of the grid (which most solar customers still rely on). What’s fair will be fought in each state individually with regulators and politicians. A very messy issue that will take years to be resolved. The risk for SolarCity are changes in the rate structure that a) will reduce the value proposition for new customers thus reducing growth and b) will increase default risk if existing customers end up paying more to SolarCity than what the utility charges.

As an entrepreneur, I am comfortable taking these risks. As a public market investor, they have to be taken into account when comparing SolarCity to other investment opportunities.

 
Summary
The macro story of the residential solar industry is strong and I am confident that overall industry growth rates will stay high for the next few years. Costs are still on a downward trajectory that will ultimately make solar economically viable to more and more Americans. SolarCity’s business model might have the winning formula if they can acquire positive NPV customers (with reasonable DCF assumptions). And do so at scale. From the information I have seen, it is difficult to tell what the fully loaded cost of a new customer is. As an investor I would also be concerned about SolarCity’s thirst for capital over the last years and its sustained losses. Our experience has been that SolarCity has always been pricing their product very aggressively in the marketplace. If that low pricing is not sustainable, increases will negatively impact growth rates and can put SolarCity in a tough spot given its high fixed cost structure. Overall, I think SCTY might be an interesting investment but not a $1bn valuation. Especially considering the negative market sentiment towards all things solar. I hope the above framework will help anyone who is interested arrive at a reasonable valuation. 

I’ve often said Solarcity’s IPO will be a watershed moment for the residential solar industry. After all Solarcity is a market leader, has raised piles of money and will be the first residential financing company to go public. On Friday the big day had arrived and Solarcity published it’s S-1 (you can read it here).

From other companies in the industry we know that the installation of solar systems is brutally competitive. A quick look at RSOL’s financials gives you a good idea: they lost $4M on $21M of revenues in Q2 2012 and currently have a market cap of $15M which is well below book value. Basically, the market is assuming the company will stay unprofitable and any value left will go towards debt holders.

So how can Solarcity avoid getting thrown into the same pot? They will be pointing towards their fully integrated business model, their strong brand and the recurring cash-flows from their residential solar leases. In this post I will focus on what I think is the most interesting of the three: the profitability of their residential lease product. Especially when considering that Solarcity has often been selling cash-purchase solar systems at negative gross margins over the last few years. Great for customers, crummy for investors.

But since most of Solarcity’s business is coming from solar leasing, understanding the economics of those leases is crucial. Here is a key disclosure made in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations”:

The gross margin on the leased systems looks very high (85% and 68% respectively) which intuitively does not make sense given the highly competitive nature of the industry. To better understand this disclosure, we have to dig deeper into the financials and the accounting treatment of operating leases.

Solarcity’s revenues are recognized over the term of the lease (usually 20 years) whereas the main capital costs are depreciated over the useful life of 30 years. Customers have different choices at the end of the 20 year lease agreement (including having the system removed from their homes) and there is no data on what will actually happen (the first leases will expire in 2027). Depending on which option the average customer chooses, GAAP might produce inflated gross profit margins on these leases. The effect could be significant: if all costs were to be recognized over 20 years, Solarcity's gross margins could be 30-50% lower.

Unfortunately, that still doesn’t paint the full picture of the profitability of Solarcity’s leases. The consolidated financial statements create a complex web that is very difficult to untangle.  They leave us guessing how the economic rent is divided between the third-party fund investors and Solarcity. Without knowing the economics (NPV, IRR, etc) of one lease unit or one investment fund, it’s unclear whether Solarcity is currently widely unprofitable because it’s investing in future profitability or whether it’s just generating unprofitable business. It will be fascinating to see how public investors will receive the stock. It will largely depend on whether they will buy into the company's growth story and whether they can get comfortable with the accounting and profitability of Solarcity's leases.

It's unusual to read something that keeps you thinking about it for days afterwards. The April Investor Letter by Jeremy Grantham is one of those reads. I recommend anyone vaguely interested in macro trends to read it. Stacked with powerful data, Jeremy Grantham  looks at recent trends of soaring commodity prices and what they mean to the world economy. Here are some highlights:

• From 1900 through 2002, commodity prices fell on average 1.2% per year (adjusted for inflation). Think about what impact a price decline of 1.2% compounded over 100+ years has had on wealth creation!
• Since 2002, prices have skyrocketed. In real terms, this increase is more extreme than any other shock to the commodity markets (e.g. the two World Wars or the oil crises of the 1980s). 
• The shock is so unusual that statistically it's highly improbable that we are still on a long-term declining price trend for most commodities.
• Jeremy Grantham argues that we are in the middle of a grant paradigm shift: the end of abundant and cheap resources. He argues that this paradigm shift is the result of unsustainable compound population growth. Since 1900 the world population has grown from 1.7 billion to about 7 billion today. And we are on the way to 8 billion by 2025.
• To appreciate the impact of population and economic growth on the demand for natural resources, just look at China. China represents about 18% of the world population and 9% of the world GDP. But with its tremendous growth China consumes 53% of the world's cement, 48% of the world's iron ore and (my favorite) 46% of the all pigs...just to list a few.
• Jeremy Grantham's conclusion is that no compound growth is sustainable and we have reached an inflection point. Although in the short-run we might see declining commodity prices because China's growth could hit a speed bump, in the long-run, the trend of falling commodity prices is clearly broken.

Maybe Robert Redford is right.

"Progress from now on has to mean something different. We’re running out of resources and we’re running out of time." - Robert Redford