rent vs. buy: financing and Solarcity (SCTY)

My California son, Brendan, got me interested in SCTY a while ago.  SCTY rents solar panels that generate electricity to individuals and to companies.

From an analytic point of view, it’s a complex and interesting firm.  It may also eventually turn out to be an important component of the nation’s power generation.  But it’s by at least a mile the riskiest stock I own (both Brendan and I hold small positions).  For instance, SCTY is a JOBS Act company , so the financials it has published to date aren’t ready for prime time.  Its business is heavily dependent on government subsidies of one type or another–and they’re shrinking.  It’s part of–but not at the heart of–the Elon Musk empire.  So holding it runs counter to the time-honored rule that you have your money as close as possible to where the entrepreneur has his–in this case, that would be Tesla, I think.

In this post, I want to use SCTY to  illustrate that in the rental model, a company can have an immense call for capital in advance of the business generating much revenue.  This can pose a significant risk.

Here goes:

First, note that I’m making the numbers simple (read:  pretty much making them up) and that there are many, many more moving parts to what SCTY does than I’m going to write about here.  But I think what I do say gets to the essence of the matter.

the business basics

1.  Look at a typical rooftop solar panel array that SCTY installs on a single family house.

–the panels cost $10,000 to build and install

–they have a 30-year life

–the homeowner signs a 20-year contract to pay $50 a month to rent them.

2.  In this industry, there’s some urgency to get panels installed on rooftops, at the very least because once someone has signed a 20-year contract, he’s not going to switch to another provider.  So the first mover has a key advantage.

financing new customers

Suppose SCTY installed panel arrays on 50,000 rooftops last year and wants to install another 100,000 this year.  What do the money flows look like?

Well, $30 million is coming in in rental income from last year’s installs.  But this year’s installation program will require $1 billion!! in capital to complete.  Where is this money going to come from?

In many senses, SCTY is a startup.  It doesn’t have deep pockets or an existing cash-generating business to use to fund the panels.  So raising $1 billion, and presumably more than that next year, is a formidable obstacle.

my point

That’s the point of this post–that the upfront capital committment in a rental business–especially involving physical stuff–can be very large.  From a financial point of view, some rental/service companies aren’t that much different from owning, say, an oil tanker, a steel blast furnace or a cement plant.  Not so glamorous if you look at them this way.

what SCTY does

The SCTY solution?  …the installed solar arrays are each sort of like a bond, that is, they pay a fixed amount of money each month for twenty years.  At the end of that period, the array still has ten years of useful life and therefore hopefully a substantial residual value.  If you package up a big bunch of them, the result doesn’t look that different from a collection of car loans or home mortgages.  In other words, the bundle is a security that you can sell to institutional investors who are looking for fixed income investments.  That’s a bare-bones version of what SCTY does.  Of course, it doesn’t hurt that SCTY is run by a financial entrepreneur.  Not every solar panel company is going to have the size or credibility to do this.

 

 

 

 

 

rent vs. buy: why rent a product instead of selling it?

Adobe (ADBE) used to sell physical copies of a given edition of its Creative Suite of products to individuals or small businesses for $2600 apiece.  Now it rents the same thing as Creative Cloud for $50 a month.  In 2012, selling physical copies (let’s ignore the other cloud-based tools ADBE sells–the big change is in its media tools), ADBE made $1.66 a share in profit and had $2.24 in cash flow.  This year, having gone totally digital the company says it will have earnings of around $.30 a share and will generate, I think, $1 or so in cash flow.

How can this be a good deal?  It takes over four years of rental income to generate the same revenue that a sale would do all at once.  In addition, in a world where interest rates were back to normal, present value considerations make the rental stream worth less than cash in hand today.

So why switch?

I can think of four reasons:

pricing umbrella   $2600 for Creative Suite, or $700 for Photoshop alone, leaves the door wide open for a competitor to enter the market with a lower-priced product–even a shareware entry–that does more or less the same thing as an ADBE product.

piracy  I’ve seen bootleg copies of Creative Suite on Craigslist for $100.  Yes, they’re illegal and, yes, maybe they won’t all work forever, but still the price difference is enormous!  Back when I was following Microsoft carefully–which is over a decade ago–that company thought that almost half of the copies of its Office suite being used by small- or mid-sized companies were stolen.  Because the rental model matches the cost of the software more closely with the potential buyer’s cash flow, stealing the software becomes much harder to justify.  If it’s all on the cloud, it’s impossible for most people to do.

upgrades (or lack thereof)  Before I signed up for the cloud version of Photoshop, I was using a version (CS5) that was several years old.  I’m sure there are individuals and businesses using much older versions.  Same general argument as for piracy–using outdated tools become much less worthwhile.

selling direct  Delivering Creative Cloud products through downloads eliminates the commissions paid to distributors of physical copies.  It also eliminates the expense of making the physical copies, but I think that’s a minor expense (the box and shrink-wrap are probably the largest cost elements).

 

ADBE thinks it will make $2 a share in 2015 and $3 a share in 2016 because of switching to the cloud for its media tools.  I’m not sure these number make the stock cheap at today’s price (I have a small position and would be a buyer at lower levels), assuming they come in as ADBE anticipates.  But I’m convinced that the piracy thing is real and that the incremental cost of selling an extra copy is as close to zero as you can get.  Also, once you start using the better tools it’s highly unlikely you’re going to go back.  You’ve probably thrown out the disks anyway.

Therefore, there’s at least a shot that number s are better than that.

But in this post, my main point is that the rental model is an extremely powerful one.

Examples tomorrow–Anixter, Olympus and EA.

equity, debt and leases: an important balance sheet change in prospect

financial strength

There’s a line of thought in academic finance that argues it doesn’t matter for a publicly traded company’s stock price how much of the capital in the business comes from equity (the owners’ cash) or debt (borrowed funds).

In the real world, that idea couldn’t be much more wrong.  Banks won’t lend to a firm that has too little cash put up by the owners.  They may even make a new equity offering a prerequisite for further loans.

Also, one of the main reasons I’m so fanatical about making a projected cash flow statement is to make sure that a company I’m interested in will have the money to service its debt, pay the dividend and still run the business.  My own rule of thumb, based on experience with a wide variety of companies, is that if a firm has so much debt that if it were to devote all its cash flow to paying back loans but couldn’t do so within three years, it’s potentially in real trouble.

debt vs. leases

Oddly, traditional financial accounting doesn’t consider leases as debt.  Even though leases may be ironclad promises to rent property or equipment for decades at a fixed price, they don’t appear on the balance sheet of the lessee as liabilities.  Lease information is disclosed, but there isn’t as much data as for bank loans or bond offerings.  What there is contained in the footnotes to the financial statements, not on the balance sheet itself.  Or course, every sensible investor should read the footnotes carefully as a matter of course.  But the reality is that even some professional securities analysts don’t.  And only the most expensive data services for screening stocks–out of the financial reach of individuals like you and me–will allow you to include leases when calculating debt/ equity ratios.

capital vs. operating leases

One exception:  at some point before my time on Wall Street began, someone got the bright idea of dressing loans up to look like leases, so they wouldn’t appear on the balance sheet.  The lessee would then appear (to anyone who didn’t read the footnotes) to be in better financial health than it actually was.

To remedy this abuse, the Financial Accounting Standards Board, the financial accounting industry watchdog, developed four tests to detect loans in lease clothing.   If the lease:

1.  calls for the leased asset to be turned over to the lessee at the end of the lease term, or

2.  allows the lessee to buy the asset at a bargain price at lease end, or

3.  lasts more than 75% of the useful life of the asset, or

4.  has payments with a total present value of over 90% of the purchase price of the asset,

then the lease is classified as a capital lease and has to appear as a liability on the balance sheet.

Leases that don’t meet any of the four criteria are called operating leases and can remain in the footnote shadows of the financials.

…until now

I haven’t made much of an attempt to find cases where the current way of accounting for leases creates a problem in company analysis.  But…

–most strip mall big box stores are stuck with long-term lease commitments for much more store space than they need.  If they can’t sublease store locations they’d like to close, however, or sublet portions of the locations they want to keep, they’re stuck paying for space they can’t use.  Borders is a case where this was an unusually difficult issue.

–on the other hand, one of the attractions of JCP (though not the most important) to its current hedge fund holders is its bargain-priced leases on retail locations.

new FASB rules…

…now in the process of being formulated would require that all leases that extend for more than a year must be shown on the balance sheet.

why this is important

Two reasons:

1.  The risks to bricks-and-mortar retailers contained in their long-term leases will become much more apparent once the new rules are in place.  Same thing for restaurant chains.  Airlines, too.  Small, fast-growing firms will likely be the worst impacted.

2.  This is a geeky, under-the-radar topic.  It probably won’t get much publicity until late this year.  Lots of time to check the lease footnotes for stock we own to make sure there are no nasty surprises lurking there.