SCTY's Road to Six Feet Under - Kerrisdale Capital Investment Case Study Competition - Spring 2015
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Kerrisdale Capital Investment Case Study Competition -
Spring 2015
SCTY’s Road to Six Feet Under
Aalto University School of Business
Oskari Färdig, Carolina Kansikas, Antti Niemi
Contents
Contents ............................................................................................................................................... 2
References .......................................................................................................................................... 14
Appendix 1: TerraForm Power Inc. (TERP) share price ................................................................... 18
Appendix 2: Selected financial information ...................................................................................... 19
2Overview: The Photovoltaics Industry and SolarCity
The market for renewable solar energy, and its most widespread applications, photovoltaic panels
(PV), has been experiencing steady growth in recent years. Installations have grown over
15 times from 2008, and the milestone of one million installations is to be reached in 2015.
Forecasts agree on the continuation of this record growth over the next two years.
However, not all players in this market are bound to survive. We believe that, beyond the current
excitement affecting renewable energy valuations, SolarCity will be the next bankrupt company of
the industry. Its unsustainable business model, poor positioning and high indebtedness combined
with inflated expectations sold to investors pave the road for the company to the hands of its
creditors.
Disadvantaged Positioning in a Market Oriented Towards Utility-Scale and Solar Farms
Solar energy can be provided either through utility-scale applications (already accounting for 60%
of the U.S market), or through distributed, rooftop solar panels. The production of energy of
distributed applications ranges from producing 8000 kW to 45000 kW of energy per year for
residential panels and commercial or industry applications, respectively. However, due to the
imperfect orientation of rooftops and the fixed costs to take into the equation, these distributed
methods are more expensive than concentrated solar farms. Solar power generators’ efficiency
grows as their size increases, and this also fuels up the economies of scale that impact strongly the
production of solar energy.
3The concrete proof for this trend is the construction of the Topaz Solar farm, the first of many
similar massive projects in the U.S. The entirety of the farms under construction will be able to
provide energy to nearly 2 million American homes at competitive costs: building large-scale
utilities result in a cost of 1.68$ per Watt, compared to 2.27$ and 3.60$ per Watt for commercial
and home systems, respectively. Regulation in some states already gives incentive to the mass
production of solar energy, requiring, for example in California that utility companies produce at
least 33% of their output from clean sources. Additionally, the offer for convenient net-metering
contracts to home-panel owners is restricted. Utility companies have both regulation, negotiation
power and economies of scale on their side, which gives grim perspectives for stable growth of
residential systems in the long term. SolarCity has focused entirely its business on rooftop
installations and is lagging behind its competitors in building larger scale plants.
While the correlation between falling brent and falling SolarCity stocks (from 65$ to 50$) might
have generated misconceptions on the relationship, the two commodities are not substitutes for
generation of electricity. Oil is mainly used for transportation fuel, not for electricity generation.
As it is not the case for substitutes, demand for solar does not decrease as its price decreases and
convergently decrease in brent prices do not affect solar demand.
Instead, companies such as SolarCity planning to build facilities in the U.S. should be aware of the
surge in supply of shale gas, which concretely is a substitute - and a cost-efficient one. As the
energy provided through solar panels is not differentiable, customers will prefer the cheaper source,
threatening this way demand for SolarCity products.
Severe Competition, Low Barriers-to-Entry and the Risky Silevo Acquisition
4Players in the PV market have to compete mainly with prices, business models and modular
efficiency. As panels present few possibilities for customization, companies tend to offer additional
services, as energy management software and power-leasing plans. SolarCity was a pioneer in
developing the power-leasing service, however, at the moment use of similar contracts is
widespread and does not offer any competitive edge. Fierce competition, along with concerns for
overcapacity, have already made 112 companies go out of business, either for insolvency,
bankruptcy, or acquisition in less than optimal conditions, and will spare only companies delivering
the highest value to customers. This industry seems not to bear idle players. Solarcity’s foes Vivint
Solar and SunPower are already grabbing the rooftop solar market share from SolarCity especially
in the Southwestern U.S. In addition, SunEdison just reported its all time high quarter with 383MW
completed, of which already 24MW residential. Moreover, barriers-to-entry to residential market
are very low, resulting in a high threat for new micro-sized entrants, as panels can be acquired from
manufacturer countries in emerging markets especially in China, where modular production is long
developed and cost-efficient.
SolarCity seems to be substantially weaker than its competitors both from a technological
advancement standpoint, and global facility positioning. For instance, the closest competitor
SunPower benefits not only from a top-of-the industry technology, which integrates efficiency
(23% vs 14-16% of competitors) and reliability (0.25% annual power degradation to 1.3%), but also
has positive trends of decreasing costs per Watt as efficiency increases, not to mention it has
already turned consistently profitable, and is continuously expanding its reach on China through
joint ventures. SunEdison just announced its plan to build a joint project of $4B and 7.5GW mega
factory in India, enabling the company to avoid tariffs and other sanctions placed for Chinese solar
products imported to U.S. and Europe. According to plans, new panels should start rolling out of
the factory to the solar panel hungry Asia in mid 2016.
5In 2014 SolarCity decided to get into the manufacturing business and bought the Fremont,
California based company Silevo, which owned a small plant in China and had plans to build a
factory in New York. Later in 2014, SolarCity announced to execute building the factory in Buffalo,
New York.
Entering the manufacturing business involves huge risks: getting the factory functioning and
producing high quality panels could take years. But most importantly, even deducting the shipping
costs from China or India, the costs in the U.S. are high. In these times of large supply of cheap
panels, Silevo acquisition and the factory decision were huge mistakes and will ensure costly,
ineffective panels for the company in the future.
SolarCity’s direct competitor SunEdison has already envisioned producing panels at a cost of $0.40
per Watt with an efficiency rate of 20% by 2016, which would enable the company to deliver
superior performance over its competitors.
The Buffalo factory was mainly financed by the State, through the Research Foundation of SUNY
in order to try to revive the Western New York Economy, and then leased for 1$ to SolarCity for 10
years. Sounds too good to be true? That’s right. The deal demands SolarCity to spend $5B during
the lease term and employ 1450 factory workers, as well as add 2000 jobs to New York in forms of
panel sales and installation. The penalty is $41.2M each year the company is unable to fulfill these
promises. So, backing up from an unsuccessful factory would be extremely expensive for the
company.
The Retained Value Puzzle
6SolarCity is trading at multiples of an unclearly determined “Retained Value”. The “Retained
Value” figure stems from the accounting decision to keep projects on the balance sheet instead of
selling them off, and makes valuation for this company exceptionally hard, with calculations
requiring numerous assumptions. The market participants’ difficulties to correctly value such assets
can be observed by looking at SunEdison’s YieldCo TerraForma’s (TERP) extremely volatile share
price (see Appendix 1 for the chart). Nevertheless, the truth behind this ambiguous figure ought to
be analyzed in more depth.
Retained value is described as the present value of cash flows streaming from solar lease
agreements. At the root of retained value are PPA contracts. Power Purchase Agreements are
agreements made between solar companies and customers, which guarantee the installation of
panels at reduced costs, or even no up-front payment at all, after which the lessee is charged by the
lessor of the energy the system produces.
The contracts of which the retained value is derived from are extremely long (ranging over 20
years). In addition, this non-GAAP measure of value usually includes value from the expectation
that a certain portion of current consumers will renew their contracts.
As with all present value calculations, results depend on the fundamental assumptions behind the
numbers. SolarCity sheds some light on the calculation of their presented retained value of $2.423
billion (as of 31th of December 2014) in their quarterly and annual statements. The company uses a
rate of 6% to discount all future cash flows into the present. They also expect that 90% of customers
will renew their contract after the length of 20 years of the initial contract. The current figure of
$2.423 billion can be broken down into two different parts: the retained value under contract, and
retained value of renewal. The former is estimated at $1.685 billion, and the latter at $738 million.
7The aforementioned assumptions can be easily challenged, resulting in less-favorable outcomes for
SolarCity.
For instance, the renewal rate of 90% in their calculations is absurd. At the end of the contract, the
associated technology will be 20 years old, whereas better and more advanced solutions will
certainly be available. Wall Street Journal’s editor Liam Denning’s analysis of the retained value
using a higher discount rate (10% compared to 6% used by SolarCity) and estimating that two
thirds of customers would renew their contract makes over a half of the retained value disappear.
This is a crucial issue for SolarCity, as previously the company has been able to finance the
initiation costs of its PV units by borrowing against the future cash flows, i.e. retained value. If this
option were to be ruled out in the future, SolarCity, in the company’s own words, would be in deep
trouble.
The importance of a higher (inflated?) retained value becomes clear under closer scrutiny. SolarCity
has issued debt instruments called SolarBonds that are backed by the future cash flows of its
retained projects. A decline in the retained value would make debtors nervous and could increase
the interest payments of such future financing significantly.
There are also other compelling risks for the lessor in this time-span, ranging from the risk of
default of the off-taker to questions over the stability of energy output, O&M uncertainty, and
interest rates. Factoring all the discussed points into the valuation, we feel that the current retained
value of $2.4 billion on SolarCity’s balance sheet is a clear overestimation.
8Moreover, there may be a non-negligible incentive problem in reporting retained value tied to the
long-term nature of the realization of these revenues. Current management will hardly be around
when the time comes for this money to actually realize, which could give incentives to
report inflated figures with preposterous assumptions.
Selling the Scheme by Painting It Green
Some congressmen and lawyers have started also filing complaints about the practices of solar
leasing. It seems risks and actual implications of this kind of financing method are not thoroughly
explained to SolarCity’s customers, who find themselves liable to fulfill obligations which may be
too high for them to bear, or might find themselves in unpleasant situation when trying to sell their
house with the long-term liability attached. SolarCity does not help homeowners to construct value
on their property, it instead deprives of the possibility to do so through more appropriate ownership
models.
SolarCity is therefore not in the solar business, it is in a financial business seasoned by green
ideology, and in a pretty deceptive one. Another poignant example of the using of the ideology for
completely different scopes is the sale of Solar Bonds by the company. As the credit rating for this
debt is below investment grade, the company is selling junk bonds to its customers vesting them
with an ideologically appealing “crowdfunding” idea.
The scheme is sadly familiar from the sub-prime loans business before the financial crisis, and
climbing sales costs are representative of a hard-sell culture, which questionably favors the best
interest of the customer. It suffices to look at the “caveat emptor” footnotes denoting an increase
9«0-2.9% each year » in SolarCity’s advertisement to denote that an increase in monthly rates of
2.9% per year could result in many customers going underwater.
Customers are already growing increasingly dissatisfied with the matter. One customer review on
Yelp depicts the SolarCity seller as “smooth-talking and lying through its teeth” , whereas positive
recommendations all picture an identical and idyllic scenario, which hardly is a coincidence.
Political Risks Involved
Under current legislation, the ITC (investment tax credit) for owning/purchasing a PV system is
eligible for 30% tax credit. This advantage is bound to cease at the end of 2016 as the credit will be
reduced to 10%. President Obama has proposed in his budget for 2016 that the ITC be made a
permanent solution. The final decision is yet to be made. Should the ITC be reduced to 10%, we
believe that this would mostly affect the industry as a whole. However, we also assess that
SolarCity would be slightly more vulnerable, as it is mostly exposed to the U.S. market, whereas its
major competitor SunEdison in the field of utility-scale production, has exposure to international
project that originally were not subject to the tax relief.
Insiders Cash in While Leaving Shareholders Waiting for Profits
SolarCity seems to present a very concentrated ownership, with insiders, executives and
management owning nearly 78% of common stock. With the company resorting strongly to debt
and third party equity financing with senior claims, the position of common shareholders seems to
be exceptionally weak, with no control over relevant matters, or rights should the company fall into
bankruptcy.
10The situation is further weakened by a rich history of insider trading (appendix) – or, should we say,
selling – which is symptomatic of potentially important negative details not being disclosed to
shareholders. Is it the owners themselves do not fully believe in the securitization fairytale they sell
to investors regarding value and are trying to capture value as long as the music is playing with
overvaluation? In fact, for investors the situation is quite opposed, and they are far from seeing
signs of either dividends or profitability.
SolarCity’s Debt Financing
Being able to obtain financing on favorable terms is a core business for the functioning of
SolarCity, The company states in its annual report for the year 2013 that: “Our ability to provide
solar energy systems to customers on an economically viable basis depends on our ability to
finance these systems with fund investors who require particular tax and other benefits.” and “Our
future ability to obtain additional financing depends on banks’ and other financing sources’
continued confidence in our business model and the renewable energy industry as a whole.”
SolarCity’s current debt financing exhibits immediate threats to its business. First, after the markets
realize the flaws in the company’s estimates of the retained value figure, it will have severe
difficulties in locking in credit to finance new projects. For example, the company issued so-called
Solar Bonds at the end of 2014. These instruments are backed by future cash flows from contracts
the company has made with its customers. As it becomes clearer that the value of these contracts is
not what is shown, securing new loans with such assets will be significantly harder. S&P rated
SolarCity’s Solar Bonds at BBB+ and BB for the senior and junior tranches respectively. The junior
tranche rated at BB is described by S&P as speculative.
Secondly, SolarCity does not have its own YieldCo, which it could use as a gateway to cheaper
capital. SunEdison, SolarCity’s competitor, has already established a well-functioning YieldCo that
11has been well received by investors due to being much more liquid than investing in Solar Bonds
for example.
After the decrease in the tax benefits (ITC) starting in 2017 combined with our analysis of the
problematic business model of SolarCity, we strongly believe that the company will have
difficulties in rolling over its debt at reasonable interest rates. This leads to a vicious cycle that will
only be stopped by SolarCity eventually going out of business.
See Appendix 2 for selected financial information.
Conclusion
SolarCity is wrongly positioned in a market directed towards utility-scale applications. As the
operations of SolarCity are largely concentrated on the residential segment, a decrease in demand in
this sector will hit adversely SolarCity more than its competitors. Moreover, its technology is
inferior to the technology of its competitors, and trying to enter the manufacturing business through
Silevo and the opening of the factory in Buffalo is a risky move, which will only degrade its
position.
The company’s business model is flawed at the least, and so is its measure, “Retained Value”.
Beyond relying on unrealistic assumptions, it fails to add value to customers and seems to present
somewhat deceptive features instead. It is also unsustainable. As the the riskiness of the subprime
assets will uncover, the company will be in trouble with denied financing and increasing required
interest rates for its debt. The high leverage of the company makes it vulnerable to decreases in
12demand, changes in the capability of charging required prices, and overall political and market
risks.
Even if the company has sold its story to yield-hungry investors under green ideology and promises
of future returns through the nebulous concept of retained value, the reality depicted from
fundamentals is quite different. SolarCity’s proposed profits are long into the future, and contain
degrees of risk not fully captured by investors. As the reality underlying its business will start
showing up, neither the backing of Elon Musk, nor the ideological infrastructure it has been
marketing will spare it from getting in deep trouble and succumbing to its competitors.
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17Appendix 1: TerraForm Power Inc. (TERP) share price
TerraForm Power Inc. (TERP) share
price
36
34
32
30
28
26
Close
24
22
18Appendix 2: Selected financial information
Profitability
Revenue Operating Income Operating Margin -%
350.00 200%
250.00 150%
100%
150.00
50%
50.00
0%
-50.00 2011 2012 2013 2014
-50%
-150.00
-100%
-250.00 -150%
-350.00 -200%
Profitability
Revenue Operating Income Operating Margin -%
150.00 200%
150%
100.00
100%
50.00
50%
0.00 0%
2014 Q1 2014 Q2 2014 Q3 2014 Q4
-50%
-50.00
-100%
-100.00
-150%
-150.00 -200%
19Indebtedness:
Total Liabilities / Total Equity
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
2011
2012
2013
2014
Indebtedness:
Total Liabilities / Total Equity
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
2014
Q1
2014
Q2
2014
Q3
2014
Q4
20Interest Coverage:
EBIT / Interest Expense
0.00
2011 2012 2013 2014
-1.00
-2.00
-3.00
-4.00
-5.00
-6.00
Interest Coverage:
EBIT / Interest Expense
0.00
2014 Q1 2014 Q2 2014 Q3 2014 Q4
-1.00
-2.00
-3.00
-4.00
-5.00
-6.00
21Retained Value Multiple Valuation:
Market Cap / Retained Value
6.00
5.00
4.00
3.00
2.00
1.00
0.00
2011 2012 2013 2014
Retained Value Multiple Valuation:
Market Cap / Retained Value
6.00
5.00
4.00
3.00
2.00
1.00
0.00
2014 Q1 2014 Q2 2014 Q3 2014 Q4
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