As we reported one month ago, on a standalone basis the pain for cash-bleeding SolarCity was only just starting. That all may have changed last night as a result of the shocking takeover proposal by a conflicted Elon Musk who surprised markets, not to mention TSLA longs, by announcing a bid for the troubled solar company. But what does it mean: many analysts are scratching their heads, however for one the outcome is clear.
As Axiom's Gordon Johnson writes: "yesterday, after-market, electric vehicle mfr. Tesla Motors (TSLA, NC) announced an all-stock offer to acquire rooftop solar bellwether SolarCity for $26.5-$28.5/shr, representing a 25%-34% premium. The reasoning? According to the 8-K (link), TSLA’s basis for acquiring SCTY is to “complete the picture”; that is, Tesla is bidding to become the only integrated energy company w/ “end-to-end” products." His take: "As we fail to fully grasp the rationale behind TSLA’s proposed acquisition of SCTY, we believe yesterday’s announcement suggests SolarCity has very little value."
Here is his rationale:
- TSLA is a high-tech car company that pioneered electric vehicles & battery storage while SCTY is a low-tech solar vendor, suggesting, in our view, few synergies beyond the obvious renewable energy relation (i.e., SolarCity buys panels, installs them on rooftops & extends financing; not a difficult model, just capital-intensive) – to wit, a car co. is proposing to buy solar co. with no tech advantage which, while both are bleeding cash, would lead to significantly neg. EPS accretion.
- The proposed premium to SCTY’s stock price is +30% (midpoint) from yesterday’s close, yet SCTY’s stock was $29.6 not two months ago (5/3) & this premium is still -44.6% below the stock’s avg. price of $49.6 during ’15 & just +2.8% above the stock’s avg. price of $26.7 in YTD ’16 – in other words, if TSLA truly believes in SCTY, then why such a modest premium?
- Can Tesla afford this? TSLA had $1.4bn of cash on its bal. sheet in 1Q & $3.2bn in debt; since then, Tesla raised $3bn in a follow-on offering (5/19), but earmarking that amount for its ambitious Model 3 prod. line, TSLA will need another ~$2.1bn of equity to acquire SCTY [= $27.5 (midpoint premium) x 76.2mn (98.3mn shares net of Elon’s 22.2mn shares already owned)] – this would again dilute existing TSLA shareholders by another 6% [= $2.1bn ÷ $32,3bn (mkt cap)].
His pessimistic conclusion: "Given the facts that SCTY is: (a) not profitable, (b) facing higher borrowing costs, & (c) likely, by our ests., to again lower ’16 installation guidance, suggesting covenant risks abound (not to mention a $250mn term loan due at yr-end), we curiously wonder out loud: if Tesla can acquire SolarCity, amid what we believe are signs of an existential crisis, then – if TSLA were to ever get into trouble – could taxpayers possibly be on the hook (i.e., could SpaceX, funded by US taxpayers, follow the same dubious corp. governance norms exhibited by TSLA/SCTY & bail out TSLA)? While we have neither the answer, nor the legal savvy, we do believe this proposed acquisition suggests SCTY is worth little value."
What does this mean in valuation terms:
Despite the premium ascribed to SCTY’s share price in yesterday’s proposed acquisition by TSLA, we firmly maintain our $7/share price target.
As we see it, at its core, SCTY 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, we continue to believe that SCTY’s valuation should resemble that of its specialty finance peers (i.e., mortgage vendors). Looking to Exhibit 1 below, observing SCTY’s specialty finance/mortgage peer group average P/B multiple of about 0.8x (held unchanged from our prior note published 5/28), which is notably skewed higher by SolarCity’s multiple, we believe the company’s fair value at present remains $7/share (67% downside from yesterday’s closing price).
Still, this may come as cold comfort to the massive short overhang in SCTY: as a reminder, of the stock's total 69 million share float, 26 million shares are short. Here, according to Johnson, are the other risks to his surprisingly low price target:
- Yesterday’s Take-Out Offer. The offer by Tesla to acquire SolarCity for a 30% premium (midpoint) lit a fire under the stock, which is unlikely going to fade much until further information/steps on the potential deal come out. Thus, given the market’s sentiment, we do see big risk to our price target.
- 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 SCTY’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 SCTY’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.
Finally, while Axiom's vendetta with SCTY has been a long-running one, here is what some other analysts say:
First, here is JPM which notes the following: "Potential Catch-22. If SCTY’s board approves this deal then it may signal a defensive stance, originating in concerns that the stand-alone company is unable to secure funding necessary to attain growth objectives. On the other hand, if the board rejects the deal, we believe the stock could come under pressure owing to incremental cost of capital. If, however, shareholders reject the deal, then we believe the firm's strategy becomes uncertain and SCTY stock could be in for an even rougher ride."
Then Credit Suisse:
And finally, Barclays: