Just What Exactly Is SolarCity's Future Under Tesla?

By Travis Hoium Markets Fool.com

SolarCity's transition to a subsidiary of Tesla (NASDAQ: TSLA) has been a little strange for the formerly dominant solar installer. The company is losing market share, shrinking installations, and now has to change its entire sales model to work with the existing Tesla sales infrastructure.

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Amid the changes, investors should look at what they can expect from SolarCity in the years ahead. Whether successful or not, here's what SolarCity's future looks like under Tesla.

Image source: Tesla.

A smaller, more focused company

There's no question that Tesla is changing the solar business at SolarCity. Installations fell in the fourth quarter of 2016 to 201 MW from 253 MW a year ago. Potentially more consequential is that cash sales were 28% of deployments, up from 4% a year ago.

Tesla clearly wants SolarCity to be a company more focused on profitable installations and cash or loan financing. This will take a lot of emphasis away from the leasing model that SolarCity was built on, but it's also a very positive move given industry trends. What we haven't yet seen is that focus turn into higher margins.

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Can solar be an add-on to EVs?

The other big strategy change Tesla is making at SolarCity is the move of the sales process away from cost-intensive door-to-door and telemarketing strategies to sales through Tesla stores. In theory, this way, customers would be highly likely to go solar before coming to SolarCity and solar panels could be an add-on to an EV.

What's unknown is whether that strategy will be successful. We know that customers who own EVs are more likely to be interested in and buy solar, but will they do so in the same transaction? Or will they want to have their EV and solar coming from the same company? That's the theory, but only time will tell.

Will SolarCity ever make money?

The challenge for Tesla in folding SolarCity into its business is to generate enough money to justify the acquisition and associated debt. In the third quarter of 2016, the final quarter SolarCity operated as an independent company, SolarCity had $257.7 million in operating costs, including $204.2 million of SG&A and R&D expenses. Extrapolated over an entire year, Tesla took on $800 million in annual operating costs that would need to be paid for somehow.

As Tesla transitions to more solar system sales and a larger energy storage business, we should see revenue and gross margins be able to cover the operating costs I highlighted. However, make no mistake, this will not be easy. In the fourth quarter of 2016, the company generated just $131.4 million in energy-related revenue, which netted a gross margin of just $3.6 million, or 2.7% of revenues.

Management said this margin will trend higher toward a 20%-25% gross margin, but it's hard to see how that happens until evidence proves it's feasible. Solar panel manufacturers, solar installers, and battery companies aren't inherently high-margin businesses and they largely operate in a commodity-type environment. Even if SolarCity is successful in its new strategy under Tesla, it may never be the huge financial success that Elon Musk and investors want it to be. And, at worst, it could be a drain of hundreds of millions of dollars in cash every year.

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Travis Hoium has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Tesla. The Motley Fool has a disclosure policy.