The Upcoming Challenges to the Solar Industry

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The sun has many shades, and solar companies come in different colors. Some companies make money by producing electricity from solar resources and then selling it to third parties. It's a "utility-like" form of business. That's the core business of First Solar (NASDAQ: FSLR), for instance. According to the company's statements, its objective is to "reduce the cost of solar electricity to levels that compete on a non-subsidized basis with the price of retail electricity." But that's not the business SolarCity (NASDAQ: SCTY) is in. SolarCity acts as a specialized financier. The company leases solar panels to homeowners on a 20-year contract, with no up-front cost to its customers. This business model is much more appealing to homeowners than the former business model which entails heavy investments in infrastructure. It's no wonder why this young company is competing head to head with SunPower (NASDAQ: SPWR) and has already more than 50,000 registered home users.

The trend is not their friend

There are a few macro-economic trends evolving that might have a strong negative impact on the business of solar companies. I'll detail them below.

Trend #1: The rise of natural gas (NG) 

The U.S is undergoing a major energy revolution. Since 2003, investors and institutions have invested in drilling on an unprecedented scale. As a result of this massive capital investment, the U.S. produced the most natural gas in history. The previous peak was in 1971. Over the past four years, gas production is up 20%. With all the new supply coming online, the price of gas crashed by more than 65%. NG is so cheap right now that it's beginning to represent a viable alternative to the expensive, dirty coal that's currently used to produce electricity. In time, this is bound to shrink the size of the average electricity bill for homeowners. In turn, all types of solar solutions will become less attractive. 

Trend #2: Solar is becoming less expensive 

Today, customers need firms like SolarCity to finance solar PV systems due to their high cost. According to SEIA, residential solar PV systems prices dropped 15.8% in Q1 2013 from a year ago. The prices have now dipped below the $5.00 per Wp level to just $4.93 per Wp. These price drops have been pretty consistent for the past several years and are expected to continue. Still, even with the price decrease, a PV system costs somewhere in the range of $30,000. However, as these prices drop significantly, homeowners may no longer need significant financing help. A small solar PV system that costs $6,000 or less might well be within reach of many individuals. This, of course, undermines SolarCity's core marketing strategy. There's no reason for homeowners to settle for high monthly lease payments if they could simply buy the whole system upfront. This trend will have a direct negative impact not only on SolarCity but on SunPower that also leases solar panels. First Solar, on the other, is likely to benefit from this trend. That's because it will become much cheaper for First Solar to produce that electricity that it later sells to third parties.

Trend #3: Unfavorable legislation for solar companies

Legislation can make or break the solar industry. Just as an example, bonus depreciation is a benefit for the industry that was completely unavailable to homeowners. In the first year, a business could take a 50% of the cost basis of the solar PV facility as a depreciation expense. The remaining 50% was then depreciated using a more traditional five year MACRS (Modified Accelerated Cost Recovery System). In the absence of new legislation, bonus depreciation will expire at the end of 2013. This will hurt the bottom-line for solar companies.

Overly stretched valuation

Tough times could be extremely challenging for solar companies. First Solar, for example, lost $40 million and $96 million in the years 2011 and 2012, respectively. That's why many people were questioning whether the company would survive in the long run. As a result, First Solar's market value fell from $27 billion to $4 billion based on these very worries. The same holds true for SunPower, which lost a staggering $613 million and $352 million in the years 2011 and 2012, respectively. With SolarCity, there aren't even profits to speak of. Yet, the company is still burning cash at an alarming rate. 

Aside from First Solar, which trades at book value and at a P/E of only 9 times earnings, other rivals are pretty expensive. Investors are willing to pay almost three times book value for SunPower, and more than 15 times (!) book value for SolarCity. It seems that all the sunny future has already been priced in.

Looking forward

The industry, as a whole, is over-dependent on government legislation and subsidies. Once NG becomes a viable substitute, the price of solar panels drop, and legislation becomes less favorable, solar companies will be closing shop. And with sky high valuations for their shares, it's going to be the investors who will be forced to run for shelter.   

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Shmulik Karpf has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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