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Deal Talk

SolarCity and Tesla Motors: Steer Clear of These Kissing Cousins

By Roger S. Conrad, on Jul. 21, 2016

Two of PayPal (NSDQ: PYPL) billionaire Elon Musk’s companies plan to join forces, with Tesla Motors (NSDQ: TSLA) announcing the proposed acquisition of SolarCity Corp (NSDQ: SCTY) for between $26.50 and $28.50 per share.

Ever the showman, Musk took to the airwaves, highlighting the potential to cross-sell SolarCity’s products in Tesla Motors’ showrooms and the synergies associated with leasing rooftop solar panels, electric-vehicle charging systems and energy-storage solutions for the home.

SolarCity’s shares surged on the news, squeezing short sellers and forcing them to cover their positions. With bets against the SolarCity consistently accounting for as much as 50 percent of the company’s float, management has triggered several short squeezes in recent years by issuing unexpectedly bullish guidance or new financing arrangements.

Tesla Motors’ stock didn’t fare so well, giving up more than 10 percent of its value in the first trading session after news of the deal broke. Over the past several years, we’ve warned Conrad’s Utility Investor readers to steer clear of the overhyped SolarCity. See, for example, the Feb. 22 installment of Income Insights, The Sun is Setting on SolarCity Corp, But Renewable Energy is for Real.

Bleeding Cash

SolarCity is the leading US distributor of rooftop solar-power systems, installing the panels and leasing them to homeowners for zero-money down. Aggressive marketing has enabled the company to distance itself from rivals.

The company’s quarterly results exhibit what can only be described as reverse economies of scale. For the past three years, the firm has lost a growing percentage of every incremental dollar of revenue generated. SolarCity grew its sales by 57 percent last year, but the company lost $1.92 for each dollar of revenue.

These challenges continued into the first quarter of 2016. Over this three-month period, SolarCity almost doubled its revenue from year-ago levels. But the company’s gross profit—revenue minus the cost of products sold—was cut almost in half.

The market has started to catch on. One-third of the 18 analysts who cover SolarCity rate the stock a buy, compared with 81 percent in September 2015. Hedge fund manager Jim Chanos, who famously forecast Enron’s implosion, has shorted SolarCity and Tesla Motors and characterized the combination of the two Musk-founded companies as “brazen and shameful,” “a bailout,” and “the worst example of corporate governance.”

Regardless of whether Chanos is talking his own book, one has to wonder whether a merger between the two companies is even necessary to realize the promised synergies–however dubious these claims may be. After all, Tesla Motors and SolarCity already cooperate in several areas. Some of Musk’s stock trades prior to the deal also raise questions about corporate governance.

To assess this deal, investors must consider two factors:

  • Whether the combination of SolarCity and Tesla Motors will be stronger than each individual company on its own; and
  • If this company has a future in a world where SolarCity and Tesla Motors’ losses continue to grow despite the rapid adoption of renewable energy.

From Leader to Laggard

Tesla Motors hasn’t experienced as much of a cash drain as SolarCity. But the company’s results still exhibit similar reverse economies of scale. Although the automaker’s first-quarter revenue grew by 22 percent year over year, its operating loss widened to 21.6 percent of sales and its operating cash flow came in at negative $249.7 million—double the previous year’s shortfall.

To be sure, Tesla Motor’s cheaper version of its much-hyped electric vehicle secured a large number of deposits from would-be buyers. But the company faces the formidable (and expensive) challenge of fulfilling these orders on time and budget, with no track record of successfully meeting previous delivery dates. Adding the money-losing SolarCity to the mix won’t make this already-gargantuan task any easier to achieve.

Solar power, electric vehicles and distributed energy are here to stay. However, SolarCity and Tesla Motors—or even the combination of the two—may not be around to participate in this revolution, let alone lead this massive change.

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Utility-scale solar-power installations operate at two to four times the cost efficiency of rooftop units, and regulated electric companies boast superior costs of capital and can recover their renewable-energy investments in their rate base.

As for SolarCity’s model, participating homeowners have discovered that their long-term leases on their solar-power units can actually lower their property values and make their homes difficult to sell at a reasonable price.

States have also cut back on subsidies to property owners who have installed rooftop solar panels. Hawaii, for example, has done away with net metering, a policy that requires utilities to purchase excess power at a premium. California—by far the biggest market for rooftop solar panels—could also head in this direction.

Tesla Motors isn’t the only automaker producing electric vehicles, and questions remain about the company’s ability to scale up production. But energy storage is the upstart carmaker’s Achilles’ heel, despite the management team’s hype about its advances in this area. Elon Musk talks a good game, but Tesla Motors is a bit player in this market.

At last month’s White House-hosted summit on Scaling Renewables and Energy Storage with Smart Markets, 17 companies presented projects for 1.3 gigawatts of grid-based energy storage slated for completion over the next five years.

AES Corp (NYSE: AES) recently announced the start-up of a 20-megawatt storage system at its regulated utility in Indiana—one of the 97 megawatts’ worth of projects that the company has brought online over the past three years. The Indiana facility will enable the utility to balance instantaneously supply fluctuations stemming from growing adoption of wind and solar power, which generate electricity intermittently.

Unlike Tesla Motors, AES Corp boasts a proprietary storage technology—Advancion 4—that power companies around the globe have licensed and implemented.

A bevy of other companies have also developed technologies that will enable the grid to work more efficiently than a rooftop solar-power system ever could. For example, NextEra Energy (NYSE: NEE), a leader in utility-scale renewable energy, has partnered with AutoGrid Systems to deploy its demand response optimization and management systems.

Despite claims that the industry faces a death spiral from distributed energy, incumbent electric utilities continue to drive adoption of clean energy while doing something that SolarCity and Tesla Motors have never accomplished: generating a profit. Investors should regard the proposed tie-up between SolarCity and Tesla Motors as an opportunity to exit these overhyped names.

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