Should You Sit Out SolarCity?

 | Jul 20, 2013 | 3:00 PM EDT
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If fundamentals are important to you, you might want to take a pass on SolarCity (SCTY). While the company has been hugely successful in positioning its business on the retail side of solar power, it also has its weaknesses. Those weaknesses may be difficult to overcome.

Here is the good news: SolarCity is not a typical solar power company. It employs a strategy that most traditional utilities avoid, by installing most of its solar panels on consumers' properties -- specifically, rooftops -- to provide solar power directly to the consumer.

Technically, this is called a "behind-the-meter" strategy. It is a retail approach that provides the highest potential for revenues. It is smart and well understood.

Here is how it works financially. Instead of selling solar power to the grid at wholesale prices, SolarCity sells power directly to consumers at retail prices. The difference between wholesale and retail power prices can be as much as 400%, depending on the state.

The model offers the potential for higher returns. The panel is a fixed investment. No matter what happens to utility prices, SolarCity's production costs remain fixed. Theoretically, as utility prices migrate upwards, the difference between solar and utility costs increases.

Here is the not-so-good news:

1. Savings may evaporate. As more consumers add panels, state regulators and utilities may become motivated to add fixed-cost items to consumers' monthly bills. They can claim the utility needs to recover additional costs for maintaining distribution infrastructure when the consumer needs power outside daylight hours. The only way to avoid that cost creep is to go "off the grid."

2. Behind-the-meter deployments incur third-party risk. The third party here -- the homeowner or business owner -- may need to fix or replace their roof; may use less power than expected; could lose their property through foreclosure; or could turn out to be slow-pay or no-pay customers. For the utility, managing third-party risk is expensive and can causetrouble with the top line.

3. Third-party Harry Homeowners require costly handholding. It is expensive to capture new retail customers (as the cell phone industry learned), and even more expensive to keep them satisfied. As long as panels remain on customers' roofs, SolarCity will need to support and interact with them to keep the fleet of panels productive. The company will need to maintain costly call centers and service centers for the economic life of their solar panels. If management takes too many shortcuts, in most states they could be subjected to corrective and punitive remedies.

4. SolarCity does not own or control the entire value chain. In an agreement announced last May, Goldman Sachs (GS) became SolarCity's financial partner in $500 million worth of rooftop systems. As such, Goldman, not SolarCity, owns a large piece of the rooftop solar lease-financing business. The question for investors becomes: Where in the value chain is the margin, and who owns that margin? One good guess might be whoever owns the leasing and financing piece.

5. SolarCity's common stock is controlled by a small group of shareholders. More than 70% of SolarCity's stock is owned by insiders and 5% by owners. This includes approximately the 21 million shares ($850 million) owned by Tesla Motors' (TSLA) Elon Musk, who is also a director of SolarCity.

6. Slapping panels on existing roofs is financially inefficient. This is particularly problematic with residential properties. (The technical challenges faced by SolarCity and its competitors was discussed last week in A Solar-Power Reawakening.) The actual amount of power a homeowner receives from rooftop panels can be far less than what the system is capable of producing.

7. A critical success factor is for the company to reach and maintain economies of scale. As of today, it appears SolarCity has not done so. At the end of the first quarter, SolarCity's customer base increased 14%, to 57,416, from 50,532 in December. There is risk the company may never reach scale.

This leads to the company's financials, which, until recently, have been horrible. They have been upside down at EBITDA and burning hundreds of millions dollars in cash. Since the Goldman deal was announced, their condition has shown improvement, although this has been lackluster.

Another concern is sustainability. It appears that SolarCity's margins might be front-loaded -- fine in the early years. As panels and rooftops age, it is likely that production will decay and costs will increase. As long as SolarCity continues to add customers, such emerging problems could be buried in the details, at least for the short term.

SolarCity is a pure but risky play on solar power. This is a stock for speculators and those wanting to ride Mr. Musk's coattails, as well as for short-term traders. However, investors desiring a company with a solid foundation may want to look elsewhere.

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