By Mike Arnold :
Investing is a difficult business. It's even more difficult when
certain industries are undergoing massive, moat-busting operating
model disruption; meanwhile, new moats materialize to defend newly
acquired competitive advantages.
With that backdrop in mind, I've shifted my investment focus
from sifting through rubble to find diamonds, pejoratively known as
the "cigar butt" approach that Warren Buffett advised against, to
finding operating models that have the potential to disrupt
industries. Stated differently, I want to find those companies with
land-grab-type operating models that have the potential to live up
to the quote: "To the victor goes the spoils."
One such company that recently caught my attention is SolarCity
( SCTY ). Before
discussing the investment theses for SolarCity, we first need to
attempt to dispel the association with solar panel makers. The
economics of solar panel manufacturing is not encouraging, and that
is precisely why SolarCity had to reprice its IPO in December 2012:
guilt by association.
The news for solar panel makers isn't getting better: case in
point, SoloPower announced on April 23, 2012 that it's pulling the plug , hopefully temporarily,
at its Portland, Oregon manufacturing facility as it searches for
But there are signs of hope in the solar manufacturing space:
ABB ( ABB ) agreed to buy Power-One ( PWER ), maker of solar
power inverters, for $1 billion. ABB CEO Joe Hogan said in the
press release: "The market is very tumultuous for solar overall and
wind power, but I really feel the strong big disrupters in the
energy market in the next 10 years are going to be shale gas and
SolarCity, though, does not sell or manufacture solar equipment,
it sells energy. CEO Lyndon Rive describes the business model as
"distributed energy generation." In other words, SolarCity is
basically a mobile utility company, like a cell phone of sorts,
while the traditional utility is more like a fixed wire line
With little to no upfront cost to consumers, SolarCity installs
a solar panel system, the mobile power plant on its customer's
rooftop. SolarCity and its investors front the installation cost
(with the help of certain tax incentives) in return for owning the
solar system and selling the energy generated to its customers at
the same or lower prices than consumers could get from the
traditional utility for the life of the agreement (usually 20
years). Any additional energy generated is sold back to traditional
utilities through a practice known as net metering.
In my mind, the SolarCity model has the potential to disrupt the
traditional, centralized power plant utility model once consumers
are educated with respect to the value proposition.
IPO and Price:
Investors appear to be beginning to understand the SolarCity
operating model and getting on board after the initial valuation
hiccup experienced in the December 2012 IPO. The stock is up some
175% from its $8 IPO price, currently valuing the company at $1.8
The IPO was initially priced at $15/share with an allotment of
10 million shares, then amended to $8/share at an 11.5 million
share allotment because of disagreement over valuation.
Interestingly, the pricing differences in the amendments to the
offering revealed that two existing investors, Draper Fisher
Jurvetson and DBL Partners, indicated the desire to subscribe to
1.5 million and 300 thousand additional shares at the lower price
point, respectively. Visionary entrepreneur of Tesla ( TSLA ), Pay Pal and
SpaceX (and cousin of CEO Lyndon Rive and CTO Peter Rive), Elon
Musk indicated his intent to commit $15 million at either
I'm certainly interested in investing alongside visionary
entrepreneurs and managers. It's served Amazon.com ( AMZN ) investors well,
letting Jeff Bezos create a moat-busting retail and web service
(click to enlarge)
So, at a $1.8 billion valuation, what are the investment theses
that could make SolarCity a winning, long-term investment as its
operating model gains traction?
Investment Thesis #1: Shift towards
In the post-2008 financial crisis world marked by high
unemployment, low wage growth and other economic headwinds, I have
noticed an increased desire among my peers (late 20's, college
educated) to be resourceful. It's trendy and likely to be etched
into the social fabric of my generation, even more so if a product
or service saves money and promotes energy conservation. If, or
rather, when, this new generation of resourceful consumers become
homeowners, I expect SolarCity to install more mobile power
Investment Thesis #2: Shift towards environmental
Investment Thesis #2 only works if Investment Thesis #1 is cost
competitive. Being resourceful, of course, means doing more with
your resources. Because SolarCity's value proposition can be
clearly modeled, value is easily quantified and measured over the
life of the contractual relationship with SolarCity.
One such example was illustrated in the Annual Report:
A Maryland homeowner sought a solar energy solution to reduce
high summertime electricity bills and ultimately decided to lease a
solar energy system from us. Over the 20-year term of the contract,
he will pay us $29,746 and is projected to create a net savings of
$8,305 compared to his projected utility bills. The solar energy
system is expected to offset 240,024 pounds of greenhouse gas
emissions over the contract term, the equivalent of planting
approximately 130 trees. The solar energy system components,
including panels, inverters and labor, cost approximately
And to quote CEO Lyndon Rive to further drive home the
When you choose to install a SolarCity solar system for your
home, you are taking the first step towards regaining control of
your energy costs without making any changes to your current
I think the last part is key: "without making any changes to
your current lifestyle." SolarCity is providing a painless solution
to a growing customer problem: expensive (and dirty) energy.
Investment Thesis #3: Ancillary beneficiary of new
Housing starts are showing significant signs of recovery from
the 2009-2012 trough. In March 2013, new housing starts were
running at a seasonally adjusted rate of 1,036,000, 46.7% higher
than the 706,000 seasonally adjusted run rate in March 2012
(Source: census.gov). This is important because new home buyers are
being educated about the SolarCity value proposition by the
homebuilders, and provided the option to install a solar
SolarCity counts the following homebuilders / building suppliers
as channel partners to help scale the business: (1) Taylor
Morrison; (2) Pulte Group (PHM); (3) Toll Brothers (TOL); (4) Home
Depot (HD); (5) Shea Properties.
Additionally, Tesla and Honda Motors (HMC) are partners in the
electric vehicle segment, representing another opportunity for
SolarCity to upsell customers through vehicle charging stations and
other ancillary offerings to increase its moat as an energy
provider for all its customers' energy needs, including
(click to enlarge)
Investment Thesis #4: Moat-like, reliable and recurring
Warren Buffett likes business models that operate like toll
bridges. It's easier for a toll bridge-like business to be
successful: toll bridges sell products and services that consumers
need, like getting across a body of water. As part of installing
the solar system, SolarCity is compensated by selling the energy
generated by the solar system to customers at a lower rate than the
customer would pay to the traditional utility.
Two types of agreements are available to customers: (1)
SolarLease or (2) a power purchase agreement. The SolarLease calls
for a pre-determined monthly payment and it includes a production
guarantee by SolarCity. Alternatively, under the power purchase
agreement, SolarCity charges the customer based on energy use.
Generally, the contracts are set for 20 years, but because the
solar systems have a 30 year life, SolarCity expects to sign
customers up for the remaining life of the system, thereby further
spreading the cost of the solar system across a longer productive
cash flow period.
It's fair to say that consumers need energy. And demand for
energy is inelastic. According to the S-1 filing , SolarCity indicated residential
utility rates in its top markets doubled over the past 20 years,
while usage did not similarly abate.
Moreover, the cost of solar panels continues to decline as the
supply/demand balance continues to be in a glut.
Therefore, it appears like there is significant pricing power in
this model: the ability to be cost competitive as electricity
prices are increased by traditional utilities, and while the
initial capital investment is reduced while generating high quality
cash flow over a long, 20 - 30 year period.
What about risk?
To properly assess any investment, the analyst must also assess
risk in the operating model. I see three, real risks in the
Tax incentives disappear : The model currently
relies on a 30% tax credit for qualified expenditures on solar
installations (which is assigned to SolarCity), and is scheduled to
be reduced to 10%, effective January 1, 2017. With the
sequestration in effect, one must ascribe at least some possibility
to the risk that the tax credits be amended. However, as the
business scales up, the recurring cash flows from its growing
customer base should help SolarCity reduce the reliance on such tax
Additional reporting burden / regulatory risk:
As a corollary to the tax incentives described above, SolarCity is
also subject to additional reporting requirements around
calculating, recording and reporting the fair market value of the
solar systems installed, which drives the reimbursements received
by the US Treasury Department as part of Section 1603 of the
American Recovery and Reinvestment Act of 2009 ("ARRA").
The company is subject to a document subpoena by the US
Treasury, along with other participants in the solar energy
installation business, requesting certain documents with respect to
the 1603 grant program. These sorts of document requests are fairly
commonplace when dealing with federal grant programs, especially
when dealing with fair market value provisions.
No allegations have been made with respect to improper
application of management's fair market value calculations, but a
slight discount may be warranted should SolarCity need to reimburse
the Treasury Department and/or fund investors.
Is the operating model a moat?: SolarCity's
distributed energy generation operating model is unique to the
energy business, but can it be copied? Sure, it could. But
SolarCity has significant first mover advantage and brand equity in
the industry, and I expect that the idea of distributed energy
generation will be embraced by consumers once they understand the
value proposition being offered.
From my recollection, it took quite some time for mobile phones
to become mainstream, and then for customers to cut the fixed line
cord. Is it possible distributed energy generation will follow the
same fact pattern?
SolarCity offers investors a compelling value proposition.
Because of that, SolarCity's operating model has the potential to
be disruptive to an entrenched utility sector as the business
scales out its distributed energy generation capability across the
country and internationally.
To be sure, it's hard to recommend shares that have seen such a
sharp rise in price in less than six months, but there may be
another way to play SolarCity while waiting for a better entry
To my peers, the resourceful-minded people looking for a job
they can get behind, visit the careers page at the SolarCity
website or become an affiliate. SolarCity is planning a land grab
for customers and to be the preferred home energy provider in the
marketplace. Be a part of it.
Disclosure: I have no positions in any stocks
mentioned, and no plans to initiate any positions within the next
72 hours. I wrote this article myself, and it expresses my own
opinions. I am not receiving compensation for it (other than from
Seeking Alpha). I have no business relationship with any company
whose stock is mentioned in this article.
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