It is rare to see such a a strong sell report from the sell-side, but Axiom just did that with Elon Musk‘s SolarCity (SCTY) and placed a price target of $7 (the stock is currently trading at $26.45 – so that indeed is rare. ZeroHedge first reported the full report (H/T to him) and readers can see the full report below. Stay tuned also for Elon Musk’s other company which has attracted short sellers, Tesla Motors. The car company reports earnings after the close today (I think).
Axiom Capital Management Investment Thesis on SolarCity Corp (SCTY).
Is The Entire Sell-Side Incorrectly Giving SolarCity Corp (SCTY) Credit For Cash It Can’t Access?
- The Good, the Bad, & the Ugly. In a widely anticipated move (evidenced by the recent outperformance of SCTY’s shrs), yesterday SCTY announced its first-ever cash equity deal w/ John Hancock Financial (“JHF”). Under the terms of the deal, SCTY will sell 95% of the cash flows generated from a portfolio of 201MW of residential & commercial solar projects to JHF over the next 20yrs. The Good: in return for the cash flows, SolarCity will receive $227mn in upfront equity, while retaining a 5% minority interest over 20yrs; including tax equity investments + upfront rebates/prepayments, this transaction will raise $3.00/W in total financing (or ~$603mn), & reflects a blend of $2.35/W for commercial projects & $3.24/W for residential projects; the IRR is ~8.2%; the majority of the installations were completed in ’15; the projects are spread over 18 states, w/ no single state comprising >35% of the portfolio; & the avg. FICO score for the residential customers is 744. The Bad: when looking at just the cash equity proceeds from this deal ($227mn) – while we recognize an additional $376mn in cash, ~$346mn of which is tax-equity (“TE”), has already been received, while, technically, TE is available for general corp. purposes, given it’s largely been spent to offset the CAPEX of the systems themselves (meaning, in reality, it is not available), we feel the relevant metric to analyze is the cash equity received, or the cash available for new project investment/debt retirement – adjusting for SCTY’s 5% ownership, a more normalized ?50% mix of SREC’s from CA, and then applying these metrics to SCTY’s existing installed base of 1.67GW (i.e., 1.8GW of cum. deployed GWs – 177MW of MyPower loans [MyPower loans have no tax equity]), adjusted for debt, the Silevo earn out, unrestricted cash, the book value of MyPower, the full renewal value, & a 35% tax rate, we derive a fair value for SCTY’s PowerCo of just $0.71/shr (Ex. 6). The Ugly: $2.71/W in costs (Ex. 7) – $1.38/W in tax equity (Ex. 8) – $0.07/W in rebates/repayments (Ex. 9) = $1.25/W in funding needs; yet cash equity proceeds from JHF were just $1.18/W, meaning SCTY sold at a loss. Caveat emptor.
- Dark Clouds Ahead? We believe a mild bookings trend borne out of SolarCity’s decision to leave NV, & withdraw MyPower, will compel an annual guidance cut when the company reports earnings next week.
SolarCity Corp (SCTY) – Investment Conclusion
SolarCity’s share price has traded down 48.2% YTD, underperforming our custom weighted-average Axiom Module/Cell OEM Index (i.e., JASO, TSL, YGE, JKS, CSIQ, CSUN, HQCL, SCTY, FSLR, SPWR, Neo Solar, Motech, Gintech, and E-Ton), which is down 31.0% YTD, and our custom Axiom Polysilicon OEM Index (GCL, WCH, DQ, REC, OCI, SOL, Sino-Am, and TBEA), which is up 5.4% YTD. Furthermore, along the same YTD timeframe, SCTY has underperformed our Axiom PV OEM Index (MBTN and ASYS), which is down 35.0% YTD, while the broader market index (as measured by the S&P 500) has returned 1.0% YTD. See Exhibit 3 below for recent share price performance and Axiom’s ratings for the stocks that make up our custom indexes.
The Good – a Nice Deal… on the Surface. There are a number of anecdotal positives associated with this deal, to include: (a) it is with a respected counterparty in John Hancock Financial (“JHF”), (b) SCTY is retaining 5% of the cash flows generated from the portfolio of 201MW of residential and commercial solar project cash flows to JHF over the next 20 years, (c) SCTY is receiving $227mn in upfront cash equity, (d) including tax equity investments and upfront rebates/prepayments, this transaction will raise $3.00/W in total financing, or roughly $603mn, (e) this transaction reflects a blend of $2.35/W for commercial projects and $3.24/W for residential projects, (f) the internal rate of return (“IRR”) on the portfolio is approximately 8.2%, (g) the majority of the installations were completed in 2015 (suggesting little risk of cherry-picked projects), (h) the projects are spread over 18 states, with no single state comprising over 35% of the portfolio (meaning California, or the highest margin state, was not the majority of the portfolio), and (i) the average FICO score for the residential customers is 744 (in line with the average score for SCTY’s aggregate portfolio of projects).
Yet, and addressing among the key bear points emboldening many of the shorts in this stock, this deal suggests, at face value, SCTY has resolved the inability to raise capital, through third-party cash-equity and tax-equity financing, in excess of its current cost (i.e., $3.00/W in total capital raised versus its current cost/W of $2.71). Stated differently, this implies SCTY has a clear path to generating free-cash-flow to fund growth.
The Bad – a Fundamental Flaw in the Anecdotal Thesis; and Why We Feel the PowerCo is Far Less Valuable than Previously Assumed. While many of our peers are raving about the $3.00/W in third-party capital this deal was able to garner, compared to SCTY’s most recent cost structure of $2.71/W, we find two major flaws with this argument. More specifically: (1) we contend the approximately $346mn in cash tax-equity associated with this deal is not available to fund growth, or retire debt, as this cash has already largely been spent to offset the CAPEX of the systems themselves (we believe this represents a general misunderstanding of how solar tax-equity works versus upfront cash equity injections), and (2) SCTY’s $2.71/W in reported C4Q15 cost is likely artificially low due to SG&A that was delayed into C1Q16 – we remind our readers that SCTY originally guided C4Q15 GAAP OPEX to $245mn to $260mn (or $252.5mn at the mid-point), but ultimately reported $227mn, with S&M well below our estimates (Exhibit 1); while we contend this optically helped their cost structure look good in C4Q15, we believe the company is now having to reverse these cuts, likely pushing costs the wrong way in C1Q16.
Valuing the PowerCo. To value the PowerCo, using the JHF as the basis, we note the following assumptions (in no particular order) – see Exhibit 6 below for buildout:
- SCTY has virtually no net-operating-loss-carryforwards (“NOLs”), implying the need to factor in some tax liability (in Exhibit 6 below, we show the impact with a 35% tax rate and without);
- 101mn in shares are outstanding;
- There are up to $150mn in Silevo earn-out payments due;
- The residential/commercial split is 73%/27%;
- SolarCity’s total current installed base is 1,670MW (or 1,847MW – 177MW in MyPower loans);
- $1.5bn in recourse debt outstanding;
- $1.2bn in non-recourse debt outstanding;
- $150mn in Silevo earn-out payments due;
- $394mn in restricted cash;
- $251mn book value for MyPower loans (we assume the book value of MyPower as a credit in our valuation framework – we do not believe SolarCity can sell these assets under similar economics as those sold in the JHF transaction as there is no associated tax equity [the math is much different]); and
- $540mn in full renewal value – $782M was the unlevered retained value as of C4Q15 for the renewal period; thus, we change the discount rate impact from 6% to 8% (using a real DCF, not their numbers and not just taking 8% over 6% which is 33%), which is 31%; thus, the unlevered retained value at 8% comes to $540 million untaxed, or $5.3/share.
Summary. When adding it all up, the full value of SolarCity’s PowerCo today, using yesterday’s JHF deal as a precedent, is $111mn (or $1.10/share) excluding taxes, or $72mn (or $0.71/share) including taxes. Under this backdrop, we remind our readers that when we first initiated coverage on SCTY 10/19/15, we were valuing the company’s PowerCo and DevCo at $14/share and $9.9/share, respectively, versus our current approach of valuing the company using a peer group of specialty financial companies. In this fashion, as the lion’s share of our peers begin to look at the value of this deal using just the cash equity portion – if SolarCity had received full proceeds the company would have reported $3.00/W × 201MW, or $603mn, but that’s not the case, and thus proceeds of $227mn were reported – we believe the lack of value in the PowerCo, and by default DevCo, will begin to crystalize in the way the Street views the longer-term valuation for this company.
The Ugly – Looking at this from the Most Simplistic of Viewpoints, it Appears SolarCity Sold these Cash Flows at a Loss. While SCTY provides a bevy of financial definitions, some of which we believe continue to confound our peers on the Street (i.e., tax equity, and its use as a form of upfront cash) as was the case with SUNE, in the most simplistic way we know how, we attempt to show readers in this section a back-of-the-envelope approach to figuring out if SCTY made money on the deal with JHF, or lost money. That is, taking SCTY’s most recently reported cost/W of $2.71 (Exhibit 7) – $1.38/W in tax equity (Exhibit 8) – $0.07/W in rebates/repayments (Exhibit 9), one can calculate SCTY’s funding needs of $1.25/W. Yet, with cash equity proceeds from the sale of 201MW of project cash flows to JHF for just $1.18/W, in the most simplistic of terms, SolarCity sold the portfolio to JHF at a loss.
Conclusion. Overall, yesterday, for all intents and purposes, SolarCity got an investment from JHF – it was not a project sale. SCTY retained ownership but, sold off 95% of their cash flows. In our view, what Consensus appears to have missed in all of this, in addition to the fact that the tax-equity cash flows are not available for immediate redeployment for growth/debt pay down, is that SCTY sold the cash flows, but kept the debt (this is not sustainable). While SCTY could indeed use the proceeds from the sale to reduce their growing debt obligation, they are likely going to use them to grow their installed base.
Stepping back, we ask our readers… would you do this? That is, would you ramp up leverage, in return for growth, at the expense of negative free cash flows? We don’t think so as it is value destructive (no matter what SolarCity says), and is being done, we believe, to show investors growth at any cost (and, as this deal shows, it is costing dearly). As this becomes more broadly understood, we expect the shares to come under intense pressure.
Updated estimates? Based on our updated model, in which we give credit to SolarCity for total solar installations of 1.10GW in 2016, versus guidance of 1.25GW, our 2016 revenue/adjusted EPS estimates adjust to $665.4mn/-$9.79, from $850.6mn/-$7.30 previously (Consensus estimates of $618.1mn/-$9.13). In addition, we introduce our 2017 revenue/adjusted EPS estimates, on 1.08GW of total solar installations, of $870.2mn/-$8.77 (Consensus estimates of $942.6mn/-$8.60). Of note, SolarCity recently shelved its MyPower loan product and concurrently confirmed that MyPower will be replaced with another, more superior loan product, yet this product has not been unveiled; for this reason, our model assumes a greater reliance on leases. See Exhibit 10 below for our SCTY consolidated pro forma statement of operations.
Valuation. As we see it, at its core, SolarCity is an originator/aggregator and servicer of residential solar leases and PPAs, or a middle man, if you will, in providing homeowners with “solar loans”, allowing consumers, who otherwise couldn’t afford it, the benefits of having a solar system installed on the rooftop (i.e., lower immediate energy costs, due mainly to government incentives [i.e., investment tax credit (“ITC”)] and favorable caveats [i.e., net metering]). By this thinking, we would go so far as to postulate that SCTY is more of a “bank” than a solar company. However, unlike a bank, which benefits when rates go up by issuing more loans at higher rates, should SCTY attempt to raise its rates to customers, customer spreads would shrink, materially tarnishing SCTY’s value proposition – stated differently, we view SCTY as a de facto bank, with all the risks, but none of the benefits.
In this fashion, as investors move to valuing SCTY as a specialty finance company, which we expect to define 2016, versus what many have historically seen as a high-growth solar vendor, we expect its valuation to move closer to that of its specialty finance (mortgage) peers.
Thus, looking to Exhibit 2 below, observing SCTY’s specialty finance/mortgage peer group average P/B multiple of about 0.9x (unchanged from our prior note), which is notably skewed higher by SolarCity’s multiple, we believe the company’s fair value at present is $7/share (74% downside from yesterday’s closing price), unchanged from our prior valuation.
Risks to Downside Price Target
While we have strong confidence in our views expressed throughout this report, we do acknowledge a number of risks to our downside 2016 year-end price target. Below, we provide some perspective on these risks.
- Net-Metering Prevails. Core to our thesis is our view that utilities are readily gaining ground against the whole net-metering argument (i.e., whether customers with solar systems should be excluded from fixed charges on their utility bills) and will likely eventually prevail. If, however, solar proponents somehow are able to get everything they want, and the states currently reviewing net-metering policies either maintain or even strengthen the status quo, our thesis would prove invalid.
- Interest Rates Stay Lower for Longer. As we see it, low interest rates enable the beneficially low cost of capital in SolarCity’s solar loans. While higher interest rates would benefit traditional financial intermediaries, which generate the preponderance of earnings based on where net interest levels are floating, we posit that SCTY cannot simply pass on higher interest to its customers, as this would erode the costs savings of installing rooftop solar. However, if the Federal Reserve indefinitely continues to refrain from raising interest rates, SCTY would be saved from this inevitability, which runs contrary to our long-term thesis.
- Financial Engineering…a Sentiment Play. As we have stated countless times before, we view SolarCity as a specialty finance / leasing company, versus a solar company. We say this given the complex products that SCTY offers and difficulty in modeling the company with any degree of precision. In other words, due to the plethora of assumptions that are required to model SCTY, we see this stock driven more by sentiment, versus fundamentals. Resultantly, following a similar “craze” that surrounded YieldCo.s last year, we acknowledge that SCTY’s stock may go higher if the company can reinvigorate investor sentiment by rolling out new, unforeseen financing products or engaging in more aggressive securitizations of its receivables. While this is a risk that would certainly void our thesis, we believe it would itself be temporary.
- High Short Interest and Inside Ownership. Given the high degree of SolarCity’s shares already sold short, we acknowledge that a potential short squeeze could result in a big move higher in the stock. Moreover, downside to SCTY’s share price could be limited by a lack of selling when considering the high amount of inside ownership.
See full report below.
