Last Tuesday, June 21, Tesla Motors (NASDAQ: TSLA) made an offer to acquire Solar City (NASDAQ: SCTY) for $2.8 billion.  Any particular bias aside, the acquisition of Solar City could make sense from a strategic point of view:

• It could help Tesla achieve its business objective to provide end-to-end sustainable energy solutions to its customers;
• Tesla could leverage Solar City’s sales force to sell EV’s (electronic vehicle) to customers with solar installations;
• Tesla could leverage Solar City’s tech force to install Tesla’s Powerwall and the battery pack.

The biggest impediment for consumers to buy an EV is the range your car can go before you need to charge it. Most EVs nowadays have enough range to commute in the city. Thinking of going on vacation with your EV? You better think twice. Currently, there is no reliable infrastructure where EV drivers can charge their cars. The result is often called range anxiety. Put simply, range anxiety is freaking out you’ll run out of battery in the middle of nowhere.

Range anxiety is real and Tesla knows it. The company has tried to address it by improving battery life but this approach takes time, costs money and it doesn’t really solve the problem. Even the longest lasting battery is bound to run out of juice at some point.

There is another solution – it’s not cheap but it is more effective. Building a network of charging stations along the major highways, just like gas stations, would do a lot better job at assuaging range anxiety than any promises of batteries with eternal life.

Elon Musk and Tesla know this. They also know that several years ago Solar City had a mutual project with Rabobank to install charging stations along Hwy 101 at Rabobank locations.

Solar City’s project with Rabobank is neat but not revolutionary. But What if Solar City were to build such an infrastructure along all major highways in the US? Such a project requires a long-term bet on EVs and them gaining major popularity nationwide.

Building a charging station infrastructure would make the sale of EVs easier but it will also provide a new revenue stream for Tesla. Just like gas stations, Tesla would charge its users for their consumption, just like gas stations do. Tesla could also benefit from a first-mover advantage by being the only game in town offering battery recharging solutions on the go.

Why Solar City Need This Deal Desperately

In the past three years Solar City has been running financial losses to the tune of $57 million a year.

Solar City’s cash flows from operations dropped with a thud in 2015 to -$790 million and since 2014 the company has been burning through cash.

The dismal financial picture is only the tip of the iceberg.  The biggest threat to Solar City’s survival is its own business model. The billionaire hedge fund manager Jim Chanos explains that “the problem with Solar City is they’re losing money on every installation and making it up on volume”.

Solar City’s business model works like this: you lease a solar PV installation from them, they install it on your roof and then you pay them rent. Solar City pays for the installation and they do the maintenance on the system if anything goes wrong.

After the lease is up, the panels are yours or you pay some nominal amount to Solar City to acquire them.

The key to making this model work is to price your panel lease in a way that they:

• pay your capital outlay over some reasonable period of time (e.g. 10 years),
• cover your annual maintenance cost,
• pay for your general overhead, and
• give you some reasonable rate of return.

In theory, this sounds like a sound model but if you scratch the surface you discover holes that would make any investor cringe.

For starters, the solar panel lease rates are market driven. Worsening economy would put pressure on Solar City to lower its lease rates in order to appeal to home owners.

Most people install solar panels on their roofs for two main reasons: because it could save them some money and because it is cool.

If the motivation of Solar City’s customers is primarily to save money by paying less in electricity prices, the incentive is not big. The only way for Solar City to increase it is to drop its lease rates, which would mean incurring even bigger losses.

If the cool factor is the primary driver, then Solar City is really riding a trend – even if it is a long-lasting one.

Even if all of the latter risks are endemic to the solar industry at large, this next one is related specifically to Solar City’s business model.

Solar City leases solar panels to home owners and makes its money by charging a lease. Since Solar City puts up the capital investment upfront to install the solar panels, it needs its customers to stay solvent and pay their lease for at least 5 to 10 years. This is how long it would take for the company to recover its original capital investment. If Solar City is forced to drop its lease rates to stay competitive, it might take longer.

If a Solar City customer defaults on the lease, the company is out of luck. It could take the panels down and re-install them somewhere else but the cost of doing this could be prohibitive.

When it comes to Solar City the risk is even higher. Most of its installations are along the coasts. You need only a regional housing crisis to wipe out most of Solar City’s active leases.

If the existing Solar City model looks like a total mess, Elon Musk offers a neat way out. By getting Tesla to buy the company, Solar City’s shareholders will get ownership in a bigger and more diversified company. Tesla would also give Solar City an opportunity to adopt a more sustainable business model and acces to larger capital markets than their current business model.

The only question that remains is, when I can drive my solar city powered Tesla across the country?

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Victor Kalchev is a financial analyst employed within in the renewable energy industry for the past several years. He holds a Master’s in Business Administration and has been involved in market valuations of renewable energy projects.