Dark Outlook for Solar City

Shares of companies operating in the solar industry have been much like the star from which they draw power – a hot topic with a bright future, but with volatile flares and filled with black spots. And with the possibility it might just implode on itself and go dark.

Recent activity in the solar industry, most notably the spectacular collapse of SunEdison (SUNE) epitomizes the dangers of businesses fueling growth by loading up on debt. I’ve made bearishness on Tesla (TSLA) abundantly clear in prior articles and now I’m turning equally negative on Elon Musk’s sister company, SolarCity (SCTY), as appears to be heading down a similarly treacherous debt-laden path that could sink its shares into the abyss. The company is set to report earnings on May 9 and that could be a catalyst for a new leg down.

It’s been well known that SolarCity has had large capital requirements as it builds out its business and despite large tax incentives for both itself and its customers for the building and installing solar panels, it has yet to turn a profit. In fact, the many solar firms faced possible extinction when tax breaks were scheduled to sunset this summer before last minute extension provided a reprieve.

But Solar City’s need for additional funding still seems dire as evidenced by its latest maneuver announced on May 4. It’s an odd deal in which it basically sold its next 20 years of potential cash flow to John Hancock Financial for $227 million. The details are such that JHF get 95% of the underlying cash flows—including solar renewable energy credits (SRECs) associated with the projects – based on per watt of solar generation capacity for SolarCity – including tax equity investments, upfront rebates and prepayments; a blend of $3.24/watt for residential projects and $2.35/watt for commercial projects.

Aside from the usual nature of the deal and that it highlights that SCTY can’t fund its own growth it may in fact be mortgaging its very future. Gordon Johnson of Axiom Capital points out two red flags; $220 million in cash tax-equity associated with this deal is not available to fund growth, or retire debt, writing, “this cash has already largely been spent to offset the CAPEX of the systems themselves. And the terms of the deal have SCTY selling the tax-equity credits below what it’s costing them. Johnson explains, “Taking SCTY’s most recently reported cost/W of $2.71 – $1.38/W in tax equity – $0.07/W in rebates/repayments, 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, SCTY sold the portfolio to JHF at a loss.”

The market agreed with the negative implications of the deal sending shares of SCTY down 10% on the news. nearly 10% back near 6 month lows.

SCTY 050516

Johnson thinks this impairment to its cash flow potential will “compelled” the company to cut its annual guidance when the company reports earnings on May 9. The company had guided a loss of $2.60 – $2.75 a share for 2016. Anything worse could send shares back down to the all-time low near the $17.50 level.

Fantastical Web Of Musk’s World

Adding another layer of intrigue and concern over Solar City’s future is the co-dependent relationship it has to founder Elan Musk and his other companies, Tesla and SpaceX. No one doubts the genius of Mr. Musk but some of his financial moves are as be as fantastical as his visions of life on Mars.

A recent article from the Wall Street Journal described the unusual, and somewhat questionable, web of financing that Musk has employed to provide liquidity his three ventures.

As the article states, “Since October 2014, SCTY  has tried to lure individual investors to the solar-power business by pitching $214 million of what it calls “solar bonds” through the company’s website. The biggest buyer by far, though, was rocket maker Space Exploration Technologies Inc., including $90 million of $105 million sold last month. In addition to the bond purchases, he has taken out $475 million in personal credit lines, buying shares of SolarCity and Tesla when they needed capital, securities filings show.”

The credit lines are secured with about $2.51 billion of Mr. Musk’s shares in SolarCity and Tesla. So in essence Musk has borrowed from himself to invest back into the companies he is borrowing from. It might not be illegal but is certainly strikes me as having a shaky financial foundation.

And actually the legality of such shifting of funds between entities is raising some eyebrows. Back in 2008 SpaceX, was struggling to develop its rocket-launch business and was running low on cash. Then it won a $1.6 billion contract from the National Aeronautics and Space Administration to send 12 unmanned cargo capsules to help resupply the international space station. Shortly thereafter in 2009 Mr. Musk personally borrowed $20 million from SpaceX which he loaned to Tesla.

Over the past two years SpaceX has received $3.2 billion for its rocket program from government contracts, according to a person familiar with the matter. The lawmakers want to make there is not a repeat of such “loans” and none of that government contract money to SpaceX money winds up at SolarCity or Tesla. Rep. Doug Lamborn (R., Colo.) this week proposed an amendment that would prohibit Mr. Musk from using SpaceX money to buy SolarCity bonds.

Which may explain why Solar City turned to John Hancock and the usual, sale of its future cash flow, and what might ultimately be its ability to survive.

I think this coming earnings report will show just how bleak it future is and I’m establishing a bearish position via a put spread. Specifically, I’m Buying June 22 Puts and selling June 17 puts for a $2.00 net debit for the spread. I expect shares to drop back down to 52-week lows near the $17 level.

— Steve Smith

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About the Author: Steve Smith