Controversial Clean Energy Stock Has Massive Upside Potential

Boom or bust. Those are the contrasting views investors seem to hold for clean energy provider SolarCity (NASDAQ: SCTY). The company — and its business model — have been fodder for both bull and bears. 

Right now, it looks like the bears are holding sway, as shares of this controversial stock have plunged 40% in the past year. Yet, I believe the bulls will have the last laugh. 

SCTY Stock Chart

SolarCity installs and leases rooftop solar panels on residential homes, which accounts for about three-quarters of sales, and commercial structures. The rapid plunge in solar panel costs, coupled with low interest rates, has enabled the company to provide electric power for lower rates than most utilities charge.

Sales have increased from $32 million in 2010 to $255 million last year, and they are expected to exceed $750 million next year. That rapid growth has led to industry market share approaching 40%.

#-ad_banner-#​SolarCity broke ground on a Gigawatt factory in Buffalo, N.Y., in September. It is expected to be fully operational in 12-24 months, and the company plans to spend $5 billion over the first 10 years of the lease. The factory will produce leading-edge solar panels with electricity conversion rates approaching the best in the industry.

The company has attracted more than $1.4 billion in capital from firms such as Goldman Sachs (NYSE: GS), Credit Suisse (NYSE: CS), JPMorgan Chase (NYSE: JPM) and Bank of America Merrill Lynch (NYSE: BAC) to fund its projects.

However, thus far, SolarCity has an unprofitable business model. In 2014, the company generated just $79 million in gross profits, but had about $450 million in overhead expenses (not to mention another $55 million in interest expense). In just the past 24 months, the company has bled roughly $2 billion in free cash flow. And the company’s growth strategy suggests it won’t be generating free cash flow for at least the next few years.

Although the company remains in the red, that’s partially due to aggressive spending on marketing. This is necessary to meet the company’s goal of sustained meteoric growth and fuel demand for its soon-to-be-online manufacturing facility in Buffalo.

The key concern for investors should revolve around the economics of particular installations. On the company’s most recent conference call, management noted gross margins per installation tend to run around 38% over the life of the lease.

Issues such as depreciation are obscuring the appearance of such margins in the near term on a GAAP basis, but they will become more evident as the company’s installed customer base matures. The investment banks, which are expected to provide even more in capital in the future, wouldn’t be backing this business model if the economics were not robust.

The company is also quickly improving the costs of its systems. Goldman notes that installation costs fell 5% in Q4 to $2.09 per watt from Q3, with a goal of reaching $1.90 per watt in 2017. Additional savings may come from a new system that can reduce installation times on commercial projects from two to three weeks to just two to three days. Goldman analysts, who have an $85 price target on shares, see gross margins rising to 49% by 2016.

The company’s cost structure is a key factor behind its surging market share in residential solar installations, which jumped from 27% in the fourth quarter of 2013 to 39% a year later. Analysts at Merrill Lynch note the company “compares especially favorably on cost to competitors like NRG Energy (NYSE: NRG).” They have a $95 price target on shares. 

Another key concern is potential threats from power companies. A ramp up in solar power production will hurt utilities’ cash flows, and some power companies are already waging a battle against current net metering regulations. These are incentives that compel utilities to credit solar-powered homes and businesses for the excess power they put on the grid. 

But the power companies’ efforts have had limited impact. California, for example, which is currently the biggest market for solar, has already extended its net metering for another 20 years.  

Frankly, the power companies can throw up as many roadblocks as they like. Eventually, technology will render them obsolete. 

SolarCity has the backing of Tesla Motors’ (NASDAQ: TSLA) Elon Musk, who is the company’s chairman. Musk has started to more frequently discuss home-based energy storage systems. In a little-noticed comment in September 2014, Musk said that all of SolarCity’s new installations will come with battery backup systems within five to 10 years.

At this point, it’s unclear if battery arrays will be completely up to the task. Batteries won’t be much help when the sun hasn’t shone for a week and no juice is flowing into the solar panels. That’s why the ultimate solution will combine some sort of combination of battery arrays, propane-fired (or gas-fired) generators and/or fuel cell systems. 

The key questions for investors are: When will we see the real breakthroughs in terms of energy storage, and what will such a system cost? 

And this is where SolarCity’s bulls come in. The key to this company’s success doesn’t ride on the fickle moods of electric utilities and their regulators; instead it is simply dependent on the evolution of existing technologies. 

In fact, signs are already emerging that we will hear more about this development path in coming quarters, which should be enough to change the discussion from “When will the company be profitable?” to “Just how huge will it be?”

Earlier, I noted SolarCity has already amassed a nearly 40% market share. Now consider that roughly 0.5% of all U.S. homes have rooftop solar. Let’s assume that SolarCity only ends up with 20% market share in 10 years. And let’s assume that 20% of all homes have solar power by then. Back-of-the-envelope math suggests this business can grow 20-fold in that time. 

Management is more squarely focused on the near term. “In order for us to achieve our million customer goal by mid-2018, we need to have a growth rate of 61%,” noted CEO Lyndon Rive on a recent conference call. He said the company’s current growth rate is 98%.

I’ll let analysts at Merrill Lynch summarize why this currently controversial stock will start to win back support: “The company’s stock price will rise as the market’s understanding of SolarCity’s business model matures.” 

Over the next few quarters, look for SolarCity to deliver on its growth promise. Management has already noted that Q1 is off to a strong start in terms of new contracts. Look for shares to rebound back toward their previous highs in the $85 range once investors come to re-embrace this high-growth business model.

Recommended Trade Setup:

— Buy SCTY at the market price
— Set stop-loss at $45
— Set initial price target at $85 for a potential 63% gain in six months

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This article originally appeared on Controversial Clean Energy Stock has Massive Upside Potential​