SCTY's Road to Six Feet Under - Kerrisdale Capital Investment Case Study Competition - Spring 2015

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SCTY's Road to Six Feet Under - Kerrisdale Capital Investment Case Study Competition - Spring 2015
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
SCTY's Road to Six Feet Under - Kerrisdale Capital Investment Case Study Competition - Spring 2015
Contents

Contents ............................................................................................................................................... 2	
  

References .......................................................................................................................................... 14	
  

Appendix 1: TerraForm Power Inc. (TERP) share price ................................................................... 18	
  

Appendix 2: Selected financial information ...................................................................................... 19	
  

                                                                             2
Overview: 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.

                                                  3
The 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

                                                    4
Players 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.

                                                 5
In 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

                                                    6
SolarCity 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.

                                                  7
The 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.

                                                   8
Moreover, 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.

                                                    10
The 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

                                                  11
has 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

                                                    12
demand, 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.

                                                 13
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Appendix 1: TerraForm Power Inc. (TERP) share price

                       TerraForm Power Inc. (TERP) share
                                    price
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              24	
  
              22	
  

                                         18
Appendix 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%

                                              19
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	
  
             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	
  

                                             20
Interest 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

                                 21
Retained 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

                            22
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