4 Red Flags in Teslas SolarCity Buyout

By Markets Fool.com

Image source: Getty Images.

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Companies don't typically go through major strategic transformations when they're simultaneously in the midst of being acquired, but Elon Musk's potential merger of SolarCity (NASDAQ: SCTY) withTesla Motors (NASDAQ: TSLA) isn't exactly a normal M&A situation. Later this week, the companies will unveil a new solar roof, an energy-storage product, and maybe tell investors a little bit more about what's going on with SolarCity's branded solar panel.

As we prepare for the product announcement -- and the Nov. 17 votes on the merger -- one can't help but think there's something off about all this activity. Here are some red flags for Tesla Motors shareholders, the stakeholders that arguably have the only real chance to block the deal.

Something's wrong with SolarCity's solar panels

When Tesla announced on Oct. 16 that it had agreed to bring Panasonic in to help with SolarCity's Buffalo, New York, solar manufacturing plant, it came as a shock to people who follow the industry closely. The Buffalo facility is being built on the idea that SolarCity can use technology it acquired from Silevo to make more efficient solar panels at a lower cost than its competitors, but that theory is falling apart.

SolarCity has been putting on a brave face since the Tesla's announcement, saying, "Together we will combine the best cell components from both and integrate them into the new solar module." The announcement that came from Tesla indicates that Telsa is going over SolarCity's head to bring in help, knowing that Silevo's technology isn't performing up to expectations. Why else would SolarCity need an outside partner that uses similar technology?

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The worst part is that the Panasonic partnership is contingent on the merger being approved. So, if Silevo is indeed having problems such that it needs to bring in a partner, that's a red flag for an independent SolarCity, and makes it a less attractive asset for Tesla to acquire.

Even Silevo's technology may not help SolarCity

Another challenge is that the "Silevo thesis" is already falling apart. When SolarCity announced the acquisition, solar panels were selling for around $0.75 per watt and were around 15% to 16% efficient. Silevo promised to bring costs down to as low as $0.55 per watt, and boost module efficiency to potentially over 20%. At worst, the thinking was, SolarCity's panel would compete with commodity products on costs, and beat them on efficiency.

But manufacturing costs have fallen faster than expected across the industry. Today, solar panels are selling for closer to $0.40 per watt, and it's easy to find high-efficiency panels approaching 20% efficiency from companies like LG or Kyocera for relatively low cost. Not only has SolarCity not proven that it can actually make the solar panel it says it can at the promised efficiency level, but it may already be able to buy such a panel on the open market at a lower price and with fewer headaches.

Whether selling solar or energy storage, Tesla and SolarCity need low cost financing. Image source: Tesla Motors.

SolarCity's financing costs are rising

The entire SolarCity business model of building and owning solar power systems is built on the idea that the company can finance projects at very low rates and generate more cash from financing them than the cost of building the systems. But the rate of return that investors demand for financing residential solar is rising, and that's terrible news for SolarCity.

It's true that the company recently went on a financing binge, raising nearly $1 billion, but that meant exchanging future value for cash today. And with rates rising, the remaining cash flows Tesla is acquiring are getting lower and lower.

I'm not sure what Tesla's plan is with SolarCity as far as financing and selling solar power systems go, but the fact that rates are rising on cash flows coming from SolarCity is terrible news for the installer over the long term.

SolarCity is losing market share

One of the interesting takeaways from the solar industry in 2016 is that national installers like SolarCity are losing market share to smaller, regional installers. According to GTM Research, first quarter 2016 installations grew 38% year over year for national installers, but 69% for regional installers. For context, SolarCity's installations grew 40% in the first quarter, so it lost market share overall.

There's been a lot of debate in the industry about what the best residential solar model is -- nationalinstallers or smaller regional installers. And there are good arguments that regional installers will be the better, lower cost option long term. Construction in general is done on a regional basis, and there are cost efficiencies smaller companies can exploit versus the overhead of a larger company. Plus, SolarCity has an incentive to stick with solar leases, but the market in general is moving toward solar sales backed with bank loans. Regional installers can better exploit the loan trend because they are willing to compete for customers on installation cost. SolarCity just can't compete with local installers on a cost basis.

If SolarCity continues to lose market share to smaller companies, that won't be a trend Tesla could easily turn around, and it may doom the returns of the acquisition.

SolarCity is a high risk bet for Tesla

As shareholders prepare to vote on Tesla's SolarCity acquisition, the moves both companies have made are a bit puzzling. Bringing Panasonic into solar manufacturing implies that Silevo's technology isn't living up to expectations and outside help is needed. As if that weren't problematic enough, financing costs are rising and SolarCity is losing market share -- all negatives for SCTY's potential parent company Tesla.

There are some big red flags around this acquisition, no matter how the product announcement goes on Oct. 28. And that should worry investors in both companies.

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Travis Hoium has no position in any stocks mentioned. The Motley Fool owns shares of and recommends SolarCity and Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.