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 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