10 Reasons The Sun Won’t Shine On Solar City’s IPO (Part 2)

Mondays are myth-busting days for us. Even if it means busting our own falsely-held assertions. And today, I’m doing just that.

Last week, I drew a comparison between SolarCity’s (Proposed Ticker: SCTY) business model and the subprime crisis.

You see, much like how banks repackaged mortgages during the housing boom, SolarCity repackages its solar energy system leases and sells them to investors in order to raise more capital and keep growing.

The problem? My comparison implies that SolarCity also focuses on subprime customers. But it doesn’t. As one reader pointed out, the company focuses on consumers with FICO scores north of 700. (A FICO score below 620 is considered subprime.)

So my analogy wasn’t perfect. Sue me!

In all seriousness, though, problematic credit quality wasn’t the crux of my argument against SolarCity’s IPO. Despite the flawed implication, the company faces many other serious – and potentially business-threatening – risks.

I highlighted five of them last week. And today I’m sharing another five before the stock begins trading later this week.

Caveat emptor!

~ Risk # 6: Money Doesn’t Grow On Trees
Management spells it out clearly in the prospectus, “Our future success depends on our ability to raise capital from third-party fund investors.”

Sorry, but third parties aren’t like the Federal Reserve. They don’t lend out money 24/7 to any interested beggar. And the reasons SolarCity’s financing could eventually dry up are numerous.

Like a rise in interest rates, a slowdown in the economy, the elimination or reduction of tax credits (see Risk #7 below), and SolarCity’s potential refusal to keep guaranteeing returns.

That’s right, the company has guaranteed a minimum return to certain investors and “may agree to similar terms in the future.” Talk about a major red flag. Why? I’ll let management tell you…

“We cannot determine the potential maximum future payments that we could have to make under these guarantees.”

There’s nothing worse than an unquantifiable uncertainty.

Now, it’s true that when the institutional investors dry up, SolarCity could securitize the leases, just like banks bundled mortgages into asset-backed securities, known as collateralized debt obligations (CDOs), to sell to everyday investors.

But, again, how well did that work out in the real estate market? It didn’t! So even if SolarCity’s securities boast high credit quality, investors are bound to be reluctant after suffering steep losses from similar investment vehicles during the financial crisis.

~ Risk #7: The Tax Man Cometh
Currently, the federal government offers a 30% tax credit for solar investments. The credit is one of the main attractions for investors providing capital to SolarCity. If it drops, SolarCity admits, “We may no longer be able to provide solar energy systems to new customers on an economically viable basis.”

Or more simply, it’s game over!

And guess what? Come January 1, 2017, the credit is already scheduled to plummet to 10%.

As Anthony Kim, a solar analyst at Bloomberg New Energy Finance, says, “It’s a ticking clock for SolarCity.” He adds, “Over the next four years, they not only have to demonstrate that they can make money, but [they also] have to change their business model and become less dependent on tax equity funds.”

Sorry, but I’m not interested in investing in a company that needs to miraculously figure out how to turn a profit at much lower tax credit levels.

~Risk #8: Growth That’s Too Good To Be True?
At first blush, SolarCity’s potential growth opportunity boggles the mind…

The company’s tapping into a $368 billion U.S. electricity market, based on 2010 data from the Energy Information Agency. At the same time, it’s also capitalizing on the craze to “go green.” Lawrence Berkeley National Laboratory estimates that from 2009 to 2020, the energy efficiency services sector will increase more than four-fold, to $80 billion.

Add it up, and SolarCity pegs its total addressable market at $170 billion per year by 2017. But it’s too good to be true.

Here’s why…

SolarCity’s systems are a value proposition. They allow customers to buy electricity for less than traditional electricity. The company says its current blended average rate is about $0.15 per kilowatt-hour, or kWh.

But how much of the total electricity sold in the United States costs more than $0.15 per kWh? Not much. Only $58 billion, or about 15% of the total market.

Thanks to increasing electricity rates of about 3.3% over the last decade, however, SolarCity estimates that its total addressable market will grow to $170 billion per year by 2017. But that’s assuming electricity prices keep increasing by the same rate – and that SolarCity’s costs don’t go up.

Both are pretty big assumptions.

What’s more, if we take into account that roughly half of U.S. households don’t have high enough credit scores to qualify for a SolarCity system, the company’s growth opportunity drops to half the advertised size. And that’s before we get to the biggest assumption about SolarCity’s growth opportunity…

The company’s systems work by interconnecting with the traditional power grid. And thanks to what’s known as net energy metering policies in 43 states, any excess power generated by the system is fed back into the grid, providing the customer with a credit. At the end of the month, the customer simply pays for the net energy used – or receives a credit at the retail rate if more energy is produced than consumed.

But what if states move away from net-metering policies? Or what if utilities don’t provide a full credit?

I’ll let management break the news: “The absence of net metering for new customers would greatly limit demand for our solar energy systems.”

Translation: There wouldn’t be any new demand. Growth potential would drop to zero.

Even if states don’t abandon net metering, they could cap it (California currently does at 5% of total peak energy demand). And if they do, “future customers will be unable to recognize the cost savings associated with net metering.”

Bottom line: Cost savings are the primary, secondary and tertiary selling point for SolarCity. If the cost benefits disappear, the sales pitch becomes nothing more than an alternative energy sale: “Go green because it’s the right thing to do.”

Sorry folks, but the market that would buy into that thinking is infinitely smaller than the one that management’s currently targeting.

~ Risk #9: Copy Me… Because You Can!
Remember Groupon (GRPN)? It had one heck of a novel business model, but nothing to prevent competitors from knocking it off. And they did… in droves. As a result, Groupon’s stock got clobbered.

Groupon proves what I told you before that being first to market is no longer enough of a competitive advantage.

SolarCity is no exception to this new reality.

Sure, SolarCity boasts six patents and 17 pending applications. But the patents relate to “installation and mounting hardware, our finance products, our monitoring solutions and our software platforms.”

None relate to the actual product the company’s selling. And they never will, because SolarCity sources the main components from the likes of Trina Solar Limited (TSL), Yingli Green Energy Holding Company (YGE) and Power-One (PWER).

Long story short, there’s nothing to prevent competitors from emerging overnight. Anyone can buy the core components from the same vendors. All it takes is money.

While SolarCity has amassed $1.57 billion in institutional investments to get off the ground, trust me, there are a lot more billions out there, ready to pounce if the model is even remotely successful.

~ Risk 10: Don’t Appraise Me, Bro!
As I’ve shown already, SolarCity is more of a financing company than a solar company. As such, appraisals are critical to its ability to secure additional financing or government grants.

Just like appraisals were critical for Americans trying to secure mortgages to purchase real estate.

You see where I’m going with this? If SolarCity’s appraisals end up being too aggressive, it can’t get any more financing, not at the same terms, at least. Not to mention, it will have to come up with capital to cover the shortfalls.

None of this is a far-fetched possibility, either.

It happened in the fourth quarter of 2011. The U.S. Treasury Department awarded the company “grants for our solar energy systems at a materially lower value than we had established in our appraisals.” And SolarCity was “required to pay our fund investors a true-up payment or contribute additional assets to the associated investment funds.”

It could happen again very soon. In October, the IRS notified SolarCity that it’s conducting audits on two of the company’s investment funds. This includes a review of – you guessed it – the fair market value of its solar power systems submitted for grants.

By the company’s own admission, a mere 5% downward adjustment would cost it $16 million.

One Final, Troubling Red Flag
If all the risks above aren’t enough to discourage you, consider this:

Throughout the company’s prospectus, management talks about a tremendous “gateway” opportunity. That is, how its solar leases open up the possibility to sell an entire suite of add-on services and products, once the distribution network is established.

Red alert! Red alert!

As I said before, when a young company looks to expand outside of its core competencies too soon in its life cycle, it’s an indication that the core business isn’t that promising.

Want proof? Consider Zynga (ZNGA) and its expansion into online gambling. And Groupon (GRPN) and its rapid expansion to offer travel deals, event tickets, retail products and everything else under the sun.

Bottom line: Investors don’t always behave rationally, so shares of SolarCity could certainly enjoy a post-IPO bounce. But it promises to be short-lived given all the risks threatening the company’s business model. So I’d add SolarCity to your list of potential stocks to sell short, not buy.

Ahead of the tape,

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