SolarCity Corporation (SCTY)

Transcription

1 SolarCity Corporation (SCTY) BESPOKE DETAILED REVIEW Provided for Client REVIEW CONTENTS: ANALYST: Key Takeaways Summary Quality of Revenue Quality of Earnings Quality of Cash Flow Corporate Governance Enitan Adebonojo, CFA, CPA , RiskMetrics Group, Inc. All rights reserved. RISKMETRICS, CFRA, QUICKSCORE, CENTER FOR FINANCIAL RESEARCH & ANALYSIS TM, CFRA ACCOUNTING LENS TM, CFRA LEGAL EDGE TM, INDUSTRY RISK ASSESSMENT PROFILE TM and IRAP TM are trademarks of RiskMetrics Group, Inc. or its affiliates. The information contained in this report may not be republished, rebroadcast or redistributed without the prior written consent of RiskMetrics Group, Inc.

2 Key Takeaway Revenues may come under pressure if changes in compensation for net metering results in lower credits/rebates, unless current contracts allow increases in rates charged. In addition, changes may result in less competitive pricing that makes solar less attractive compared to traditional energy solutions. The net present value of future net cash inflow expected from installed solar panels appears inflated due to the discount rate used by the Company for its analysis. Decline in margins for solar system sales suggest profitability is challenging. Negative outcome of an investigation by the IG and IRS could have significant negative financial impact on SCTY. Earnings in September 2013 benefited from lower warranty provisions and selling and marketing expense. Presentation of operating cash flow benefits from exclusion of payments for solar systems. Summary QUALITY OF REVENUE P.3 If states that offer solar customers net metering make any changes that result in lower compensation for excess power produced and pushed to the grid, it will have a negative impact on SCTY s revenues from existing contracts. This is due to the fact that net metering credits are assigned to the Company and have been factored into determining fixed monthly payments and possibly rates in power purchase agreements. If the existing contracts do not allow the Company to a pass along higher costs as a result of lower credits from net metering or other incentives, revenues will decline as incentives are currently recognized as additional revenue. Retained value may be inflated due to the discount rate used for discounting future cash flows. Negative outcome of the investigation of possible overstatement of fair value of solar systems used to claim grants other incentives would have a significant negative impact on SCTY s operations. QUALITY OF EARNINGS P.8 Gross margin for solar energy systems declined to an eight-quarter low in September 2013 despite growth in sales, which suggests profitability remains challenging. Margins benefited in the September quarter from (1) lower warranty provision, which may lead to higher future charges as warranty claims rise with the age of the solar systems, and (2) lower selling and marketing expense. QUALITY OF CASH FLOW/LIQUIDITY P.11 SCTY presents payments for solar energy systems as an investing activity even though the panels are the primary source of revenues. It is arguable that this cash outflow should be presented as an operating activity. There is no consistency among similar companies that generate revenues from renting or leasing capital assets. Operating cash flow would be consistently negative if SCTY classified solar system costs as an operating activity. CORPORATE GOVERNANCE P.12 SCTY reported related party transactions with Teslar, which may not have been negotiated at arm s length. Inconsistency in disclosure of a non-gaap metric may signal weakness in internal controls over financial reporting. Fiscal 2013 is the first time that SCTY s internal controls will be evaluated and audited. SOURCE DOCUMENTS December K September Q Filing December K Filing 5-years of financial data RELATED IRAP Electrical Equipment CFRA SCORE Cash Flow Score: 1 st Decile Earnings Score: 9 th Decile 2

3 Quality of Revenue RISK TO FUTURE REVENUE GROWTH FROM CHANGES IN STRUCTURE OF NET METERING Any changes that results in reduction of credits issued to customers for net metering will likely have a negative impact on revenues from SCTY s existing contracts where (1) customers pay a fixed monthly payment (under lease agreements), or (2) the Company is unable to pass on increased costs to customers that pay fees per kwh based on amount of electricity produced (under power purchase agreements). In addition, reductions in credits for net metering on future installations may make it difficult for SCTY to offer competitive prices to prospective customers. As highlighted in SCTY s September 10-Q, one of the risk factors for its business is as follows: We rely on net metering and related policies to offer competitive pricing to our customers in some of our key markets. Forty-three states and Washington, D.C. have a regulatory policy known as net energy metering, or net metering. Each of the states where we currently serve customers has adopted a net metering policy except for Texas, where certain individual utilities have adopted net metering or a policy similar to net metering. Net metering typically allows our customers to interconnect their on-site solar energy systems to the utility grid and offset their utility electricity purchases by receiving a bill credit at the utility s retail rate for energy generated by their solar energy system in excess of electric load that is exported to the grid. At the end of the billing period, the customer simply pays for the net energy used or receives a credit at the retail rate if more energy is produced than consumed. Utilities operating in states without a net metering policy may receive solar electricity that is exported to the grid at times when there is no simultaneous energy demand by the customer to utilize the generation onsite without providing retail compensation to the customer for this generation. Our ability to sell solar energy systems or the electricity they generate may be adversely impacted by the failure to expand existing limits on the amount of net metering in states that have implemented it, the failure to adopt a net metering policy where it currently is not in place or the imposition of new charges that only or disproportionately impact customers that utilize net metering. Our ability to sell solar energy systems or the electricity they generate also may be adversely impacted by the unavailability of expedited or simplified interconnection for grid-tied solar energy systems or any limitation on the number of customer interconnections or amount of solar energy that utilities are required to allow in their service territory or some part of the grid. Limits on net metering, interconnection of solar energy systems and other operational policies in key markets could limit the number of solar energy systems installed there. For example, California utilities are currently required to provide net metering to their customers until the total generating capacity of net metered systems exceeds 5% of the utilities aggregate customer peak demand. This cap on net metering in California was increased to 5% in 2010 as utilities neared the prior cap of 2.5%. If the current net metering caps in California, or other jurisdictions, are reached, future customers will be unable to recognize the current cost savings associated with net metering. We substantially rely on net metering when we establish competitive pricing for our prospective customers. The absence of net metering for new customers would greatly limit demand for our solar energy systems. In the above disclosure, SCTY acknowledges the risk that limits on net metering poses for demand for energy solar systems. California s current debate to change (i.e. lower) rates for net metering could have an impact on SCTY s ability to get new customers. In the current proposed ruling, homeowners who currently have or install solar panels 3

4 on the roofs before January 1, 2017 will be allowed to stay on the current net metering rates for a transition period of 20 years, which will be measured from the day a rooftop system goes online. (See A California compromise on the net metering transition? ) Under the current practice in California owners get credit at full retail rates per kilowatt hour pushed to the grid, which can be used to offset the cost of any electricity the owner uses from the grid. In addition, under the current arrangement customers can zero-out their bills and receive payment at the end of twelve-month period for net surplus generation, according to Future legislation may result in lower rates of compensation for net metering that is below the current retail rates, which will result in higher costs for solar panel owners. VALUATION OF ESTIMATED FUTURE PROCEEDS (RETAINED VALUE) MAY BE LOFTY SCTY s valuation of future net proceeds from existing energy contracts, which the Company calls retained value, may be inflated due to the discount rate used by the Company. The Company uses 6% as its discount rate to estimate the net present value of future contractual payments plus estimated payments on future renewals less payments to investors, depreciation of solar panels, replacement of inverters, maintenance, insurance and administrative costs, etc. However, CFRA believes that SCTY should use its weighted average cost of capital (WACC), which we estimate is closer to 8.72%. The derived net present value would be lower based on the higher discount rate. According to SCTY, Retained Value forecast represents the sum of both Retained Value under Energy Contract and Retained Value Renewal. Retained Value Under Energy Contract represents the forecasted net present value of Nominal Contracted Payments Remaining and estimated performancebased incentives allocated to us, net of amounts we are obligated to distribute to our fund investors, upfront rebates, depreciation, renewable energy certificates, solar renewable energy certificates and estimated operations and maintenance, insurance, administrative and inverter replacement costs. This metric includes Energy Contracts for solar energy systems deployed and in Backlog. Retained Value of Renewal represents the forecasted net present value of the payments SolarCity would receive upon Energy Contract renewal through a total term of 30 years, assuming all Energy Contracts are renewed at a rate equal to 90% of the contractual rate in effect at expiration of the initial term. This metric is net of estimated operations and maintenance, insurance, administrative and inverter replacement costs and includes Energy Contracts for solar energy systems deployed and in Backlog. Our calculation of retained value assumes a discount rate of 6%. [Emphasis by CFRA] SCTY does not discuss or disclose the basis for the discount rate it uses, and as such we are unable to determine the veracity of their assumptions. However, our estimate of SCTY s WACC suggests the discount rate should be higher. Based on our estimated WACC, we also estimated what SCTY s retained value should be, by projecting a future value for the reported retained value and discounting back to the present based on the calculated WACC. Our result suggests that SCTY s reported retained value is inflated by a range of 32% to 47% depending on the actual average life of contracts captured by the Company s calculation, holding all other inputs constant. (See Table 1.) Note that there are numerous unknown inputs in SCTY s analysis including but not limited to projected fees from the renewal period (that extend to the 30 year life of the panels which is beyond the typical 20 year contract life), obligated distributions and future expenses that prevent an analysis based on the reported nominal contractual value. 4

5 While our analysis may not be 100% accurate, assuming no other changes to SCTY s assumptions a higher WACC would result in a lower net present value. Questions for Management: 1. What is the basis for the 6% discount rate used for calculating Retained Value? 2. If the 6% discount rate does represent a calculation of WACC, what are the inputs including cost of equity? Table 1: Company Reported Retained Value Significantly Exceeds CFRA Estimate based on Est. WACC $ in millions, ex % As of December 2013 Assumed Average Contract Life Retained Value as Reported 1,052 1,052 1,052 CFRA Estimated Future Value 1 4,515 3,374 2,521 CFRA Estimated Retained Value Company Reported Retained Value less CFRA Est % Difference of Excess in Reported Retained Value 46.9% 39.7% 31.6% 1. Calculated based on Company s discount rate of 6%, and our assumption of average life for contracts, including the renewal period. 2. Estimated NPV based on our estimate of 8.72% WACC. REVENUE GROWTH IS SOMEWHAT VOLATILE, BUT GROWTH IN CONTRACTED PAYMENTS APPEARS ROBUST SCTY s total year-over-year revenue growth accelerated in the latest quarter mostly due to faster growth in solar system energy sales in contract to negative growth in four of the prior five quarters. Specifically, total revenue grew 87.2% in the December 2013 quarter, up from 52.0% in the September 2013 quarter, due to 121.5% growth in solar energy system sales slightly offset by slower growth of 59.6% in operating leases. (See Table 2a.) Given continued growth in average nominal contracted payments, we expect that future lease revenue will continue to grow. (See Table 2b.) Despite the recent growth, SCTY s total revenue growth will remain volatile as long as a significant portion of its revenues are derived from solar energy system sales, which accounted for 45.7% to 52.6% of total revenues in the last four quarters. (See Table 2c.) Table 2a: Total Year-over-Year Revenue Growth Accelerates in the Latest Quarter Dec-13 Sep-13 Jun-13 Mar-13 Dec-12 Sep-12 Jun-12 Mar-12 YoY Revenue Growth 87.2% 52.0% -18.5% 20.7% 21.8% -17.6% 129.7% 242.9% Operating Leases 59.6% 78.2% 78.8% 85.4% 99.3% -13.6% 26.7% 138.2% Solar Energy System Sales 121.5% 31.8% -50.5% -10.8% -17.9% -20.5% 213.5% 336.4% 5

6 Table 2b: YoY Growth in Average Nominal Contracted Payments Remains Robust $ millions Dec-13 Sep-13 Jun-13 Mar-13 Dec-12 Dec-11 Dec-11 Average Nominal Contracted Payments 1,989 1,737 1,409 1,222 1, YoY Growth 79.4% 128.3% 77.8% Seq. Growth 14.5% 23.3% 15.3% 10.2% Table 2c: Percentage of Total Revenue from Leases versus Solar Energy System Sales Dec-13 Sep-13 Jun-13 Mar-13 Dec-12 Sep-12 Jun-12 Mar-12 Dec-11 Sep-11 Operating Leases 47.4% 51.0% 54.3% 50.3% 55.5% 43.5% 24.8% 32.8% 34.0% 41.5% Solar Energy System Sales 52.6% 49.0% 45.7% 49.7% 44.5% 56.5% 75.2% 67.2% 66.0% 58.5% ACCOUNTS RECEIVABLE IS WITHIN THE HISTORICAL RANGE Despite a slight sequential increase in the level accounts receivable, the current level is well below the year ago level. Given seasonality in the business, year-over-year comparisons are more appropriate. As shown on Table 3, accounts receivable measured in days amounted to 62 days as of September 2013, down from 116 days in the year-ago period and slightly up from 58 days in the prior two quarters. SCTY did not disclose any balance sheet accounts in its announcement regarding a delay in its earnings release for the December 2013 quarter, and as such we are unable to assess receivables as of that date. Table 3: Accounts Receivable is Close to Low-End of Historical Range $ mils, ex DSO in days Dec-13 Sep-13 Jun-13 Mar-13 Dec-12 Sep-12 Jun-12 Mar-12 Accounts Receivable, net NA NA 10.7 Total Revenue DSO Trade Receivables NA NA 47 Dec-11 CUSTOMER DEPOSITS AND DEFERRED REVENUE INCREASED IN AGGREGATE, BUT THERE IS RISK TO DEFERRED REVENUE BASED ON OUTCOME OF ONGOING INVESTIGATIONS SCTY s customer deposits appear volatile and fell back to a prior low in the September 2013 quarter. However, both current and long-term deferred revenue measured in days (DSDR) increased year-over-year in the three quarters for which there is comparable prior year data. In addition, the level of increase in deferred revenue more than offsets the decline in customer deposits which mitigates the risk of a slowdown in future growth from lower customer deposits. Specifically, customer deposits measured in days amounted to 17 days as of September 2013, down from 29 days in the prior year and 19 days in the prior quarter. However, the 24 day year-over-year increase in current deferred revenue more than offsets the 12 day decline in customer deposits. SCTY reports deferred revenue, which includes 6

7 upfront lease payments received from customers and solar energy systems incentive rebate payments received from various state and local governments, and also reports deferred U.S. Treasury grants income. For the purposes of our analysis, we have combined both deferred revenue and deferred grant income for our analysis of deferred revenue. (See Table 4.) Risk to Deferred Revenue from Ongoing Investigation by U.S. Department of Treasury and the IRS: The risk of loss associated with the investigation regarding SCTY s claims for grants under Section 1603 of the American Recovery and Reinvestment Act of 2009, may be understated. SCTY is being investigated by the Inspector General (IG) of the U.S. Department of Treasury for possible misrepresentation of the fair market value of solar power systems submitted for grants under the Recovery Act. According to CFRA s Legal Edge team, it is possible that SCTY is being investigated by the IG for possible False Claims Act violation on the cash grants, which would typically carry up to treble damages. However, in its risk disclosure where the Company states it may have to refund grants to the Treasury, the Company does not address the range of damages that could be assessed. SCTY disclosure only addresses its estimate of what it would have to repay to fund investors should the investigation determine the reported fair value of solar power systems used to determine grants was overstated. SCTY s hypothetical scenario estimates that it would be obligated to repay $24.8 million to fund investors for a 5% downward adjustment in the fair value of approximately $495.8 million that have been awarded by the Treasury for claims submitted by SCTY from the inception of the program through September for its solar power systems. However, the amount that SCTY would have to repay Treasury could be as much as three times the amount of excess claims. In addition, the Internal Revenue Service audit may determine that tax credits previously claimed in connection with installed solar power systems for which fair value was excessive, must be reduced in which case, SCTY may have to pay interest and penalties in connection with those tax credits. To the extent that the outcome of these cases are unfavorable, SCTY will have to reduce its deferred revenue for any amount of grants or tax credits it previously received and has to repay. Table 4: Customer Deposits at Low-End of Historical Range, while Deferred Revenue has Increased $ mils, ex days Dec-13 Sep-13 Jun-13 Mar-13 Dec-12 Sep-12 Jun-12 Mar-12 Dec-11 Customer Deposits Deferred Revenue - Current Deferred Revenue Long Term Total Revenue DSCD (days in Customer Deposits) DSDR Current DSDR Long Term 1,386 1,614 1,793 1,774 1, ,027 7

8 Quality of Earnings SOLAR ENERGY SYSTEMS MARGIN WEAKEND IN SEPTEMBER DESPITE SALES GROWTH; SUGGESTS PROFITABILITY WILL REMAIN CHALLENGING SCTY s total gross margin declined in the September 2013 quarter due to deterioration in gross margin related to energy system sales, which fell to the lowest level in eight quarters. In the discussion regarding the nominal increase in the cost of solar energy systems in the September Q, SCTY attributed part of the increase to $2.2 million more losses arising from allocation of indirect costs from solar energy systems contract sales contracts. However, there was no discussion of the nature of the indirect costs and the likelihood of reoccurrence. Even when we exclude the impact of the additional losses from gross margin calculation, gross margin for Solar Energy System sales still falls to 14.1% versus the reported 4.9%, both of which are below the year ago margin of 23.0%. (See Table 5a.) We have no reason to believe that these losses should be excluded from any analysis of the Company s profitability. Even though there was a reduction in average selling price, which the Company attributed to lower cost of system components that in turn led to the downward impact on the competitive market price of solar energy systems sold, it appears that lower average selling price did not contribute to the lower margins. Per our analysis on Table 5b, assuming SCTY passes 100% of reductions in cost of solar energy components to its customers, and all else remains unchanged, a reduction in cost of sales with an equal decline in sales will result in an increase in SCTY s gross margin. As such, the recent decline in gross margin suggests SCTY has not received any benefit from growth in the size of its business, and overall costs have risen. If accurate, SCTY s ability to turn a profit will remain challenging. Table 5a: Total Gross Margin Falls to the Lowest Level in Five Quarters Sep-13 Jun-13 Mar-13 Dec-12 Sep-12 Jun-12 Mar-12 Dec-11 Sep-11 Total Gross Margin 36.1% 40.8% 42.3% 55.5% 49.3% 23.5% 40.8% 40.1% 10.6% GM Operating Leases 66.0% 65.0% 63.5% 66.3% 83.3% 67.8% 68.3% 65.5% 79.6% GM Solar Energy System Sales 4.9% 12.1% 20.9% 42.1% 23.0% 9.0% 27.4% 27.0% -38.4% Table 5b: Gross Margin Increases when Lower Cost of Systems are Passed on to Customers Post Pre 20% Price reduction 20% Price Reduction Average Selling Price Cost of Sales Solar Energy Systems GM Solar Energy System Sales 33.8% 27.0% 8

9 LOWER WARRANTY PROVISIONS MAY LEAD TO HIGHER FUTURE CHARGES AND MARGIN PRESSURE SCTY s gross margin for energy solar system sales benefited from a decline in warranty provisions recorded in the September quarter. Specifically, warranty provisions fell to $466K or 2.0% of system sales in September 2013, from $926K or 5.3% of system sales in June, and $776K or 5.2% of system sales in March Had the Company recorded provisions at the prior quarter level, warranty provisions charged would have been $805K higher in the September 2013 quarter and gross margin would have been 1.5% for energy system sales, which is 3.4% lower than reported. While it may appear that the decline in provisions s justified given the current low level of warranty claims, it is possible that warranty claims may rise in the future as systems sold to date are likely still in the early stage of the product life which SCTY has estimated is 30 years. Table 6: Warranty Provision Declined Relative to Solar Energy System Sales In $ millions, ex % Dec-12 Sep-13 Jun-13 Mar-13 Warranty Reserve Beginning Balance Dec-12 Provisions Charged Warranty Claims (0.050) (0.072) (0.084) Warranty Reserve Ending Balance Solar Energy System Sales Provision Charged / System Sales 2.0% 5.3% 5.2% EARNINGS BENEFITED FROM LOWER LEVEL OF SELLING AND MARKETING EXPENSE IN SEPTEMBER 2013 SCTY s earnings for the September 2013 quarter benefited from a decline in the level of selling and marketing expense. While expenses increased in nominal terms SCTY stated that the increase was partially offset by $0.8 million decrease in marketing events expense. This decline appears to be unsustainable as the Company stated in the September 10-Q filing that it expects selling and marketing expense will increase in the future. OTHER ACCOUNTS NOT CONCERNING Based on our analysis and review of other accounts including inventory level measured in days (DSI), depreciation and expense, prepaid expense and other current assets, and accrued and other current liabilities, we found no evidence to suggest that these accounts have been manipulated in order to boost earnings or that there is risk of future margin pressure. 9

10 Inventory level declined to the lowest level for the two year period that we have financial data. CFRA is typically concerned by significant increases in inventory level that can lead to impairment and pressure margins in future periods. Depreciation expense as a percentage of average gross solar energy systems leased to customer and property & equipment has remained flat in the last four quarters. As such, we are not concerned that the Company has slowed down its depreciation rate. Prepaid expenses and other current assets increased from the prior year level but remained within range. Even though we would normally be concerned by the magnitude of the increase, which might suggest increased cost capitalization, any concern raised is mitigated by the fact that accrued & other current liabilities rose even faster. As such, we are not concerned. Accrued and other current liabilities increased as a percentage of revenue from the prior year level. Typically, CFRA is concerned when accrued liabilities decline significantly as it may signal lower than usual accrual of expense that may have benefited earnings. Table 7: Trend in Other Accounts Dec-13 Sep-13 Jun-13 Mar-13 Dec-12 Sep-12 Jun-12 Mar-12 Dec-11 Inventory in Days (DSI) , ,302 Depr. Exp. / Ave. Net Solar Systems Leased and Property & Equipment 0.8% 0.8% 0.8% 0.8% 0.7% Prepaid Exp. & Other Current Assets / Rev 52.5% 68.1% 87.7% 45.5% 41.6% 40.5% 86.2% Accrued & Other Liabilities / Revenue 106.6% 115.3% 121.4% 186.7% 84.0% 54.5% 130.7% 10

11 Quality of Cash Flow / Liquidity PRESENTATION OF OPEARATING CASH FLOW BENEFITS FROM EXCLUSION OF PAYMENTS FOR SOLAR SYSTEMS While CFRA did not find any evidence of cash flow manipulation or unsustainable boosts in recent periods, it is arguable that payments related to solar energy systems should be presented as an operating cash outflow and not as an investing cash flow. Nevertheless, trailing-twelve-month (TTM) FCF which includes payments for solar systems as well as investments in property and equipment (capex) has been persistently negative. (See Table 8.) SCTY will need to continue raising capital to fund additional investments in solar systems as CFFO has not been sufficient to fund this investment. For comparison we looked at Rent a Center Inc. (RCII) and Aron Rents, Inc. (ANN) and both companies classify cost of revenue generating merchandise as an operating activity, but in contrast Hertz Inc. (HTZ) that leases automobiles classifies similar cost as an investing activity. For companies like this it is important for investors to pay more attention to free cash flow (FCF) versus cash flow from operation (CFFO). Liquidity should not be an issue in the near term as the Company had as of September 2013 $133 million in cash and cash equivalents of versus $39.2 million for current debt and lease obligations. Although SCTY has revolving credit facility, we were unable to determine how much was available as of September Table 8: Trend in TTM Operating and Free Cash Flow $ millions Dec-13 Sep-13 Jun-13 Mar-13 Dec-12 Sep-12 Jun-12 Mar-12 Dec-11 Sep-11 CFFO (76.9) 82.3 (51.7) Pymt for Solar Energy Systems (211.4) (158.0) (138.2) (150.3) (115.8) (91.1) (83.5) (91.5) (77.1) CFRA Adjusted CFFO (111.4) (84.0) (129.3) (85.6) (81.7) (52.7) (160.4) (9.2) (128.8) Capex (1.9) (1.5) (2.4) (1.0) (1.4) (2.6) (3.4) (3.8) (1.1) FCF (113.4) (85.5) (131.7) (86.6) (83.2) (55.3) (163.7) (13.0) (129.9) TTM CFFO, as reported (7.9) CFRA Adjusted TTM CFFO (410.4) (380.7) (349.3) (380.4) (304.0) (351.0) TTM FCF (417.1) (387.0) (356.7) (388.7) (315.2) (361.9) 11

12 Corporate Governance RELATED PARTY TRANSACTIONS SCTY disclosed the following related party transactions in its latest proxy filing: Transactions with Tesla Motors We have entered into a number of agreements with Tesla Motors, Inc. Mr. Musk, the chairman of our board of directors, is the chief executive officer, product architect, chairman of the board of directors and a significant stockholder of Tesla. Mr. Straubel, a member of our board of directors, is the chief technology officer of Tesla. Mr. Gracias, a member of our board of directors, also is a member of the board of directors of Tesla. Mr. Fisher, a member of our board of directors, is a managing director of Draper Fisher Jurvetson which is a minority stockholder of Tesla. In January 2011, we entered into a professional services agreement with Tesla under which Tesla subcontracted with us for us to pay Tesla to provide a variety of design, engineering and consulting services as part of a grant under the California Solar Initiative of the California Public Utilities Commission. As of December 31, 2012, all work under this agreement has been completed. Pursuant to this agreement, we paid Tesla approximately $283,000 for services provided in 2011 and approximately $229,000 for services provided in We also from time to time to install Tesla s Superchargers and related equipment, including solar panels we provide for use as part of the Superchargers. We have invoiced Tesla approximately $910,000 for such installation services and equipment we provided in In September 2012, we entered into a professional services agreement with Tesla (the Services Agreement ) whereby Tesla agrees to refer to us Tesla customers who have indicated their intent to consult with us for the installation of in-home electric vehicle supply equipment for use with Tesla vehicles. Under this agreement, we agreed to pay Tesla referral fees in respect of each customer who purchases from us solar photovoltaic equipment or energy efficiency upgrade services. During the 2012 fiscal year, we paid Tesla approximately $2,900 for such referral fees. The Services Agreement does not provide for any payment obligations by Tesla. In April 2013, we entered into a supply agreement with Tesla under which Tesla will supply us with various sizes of stationary batteries for integration with our solar panels to create stationary power sources for sale or lease to residential and commercial customers. We will pay Tesla for any stationary batteries supplied to us pursuant to this supply agreement. In the September Q, SCTY reported that it purchased inventory worth $975K in the nine month period from a related party with no amounts reported for the nine months through September 2012, which suggests that the above disclosure, which relate to fiscal 2012 all occurred in the December 2012 quarter. Although no revenue has been recognized from related parties, $831K of the Company s deferred revenue as of September 2013 is from a related party. CFRA typically raises concern that transactions with related parties or entities affiliated with related parties may not have been negotiated at arm s length. 12

13 POSSIBLE WEAKNESS IN INTERNAL CONTROLS In connection with audits of 2010 and 2011 financial statements, SCTY identified material weaknesses in its internal controls over financial reporting and inventory processes, which resulted in restatement of 2010 financials. As of September 2013 the Company had not performed an evaluation of its internal controls as required by Section 404 of the Sarbanes-Oxley Act, nor had its internal controls been audited by a CPA firm. In the September 10-Q, SCTY stated that its first internal control over financial reporting evaluation and audit will be required for the year ended December Given that this is the first audit of the internal controls by the auditor, there is risk that additional weaknesses may be found. We noted inconsistencies in the disclosure of cumulative number of customers, a non-gaap metric. (See Table 9.) it is not clear whether the Company changed how it determines the metric as it went from referring to it as number of customers in both the March Q and December K filings, to referring to it as cumulative number of customers in subsequent filings. Nonetheless, the number of cumulative customers disclosed for December 2012 in the June 10-Q differed from the number disclosed in the September 10-Q. Even though this metric is non-gaap the inconsistency suggests possible weakness in internal controls. Table 9: Inconsistent Disclosure of Number of Customers as of December 2012 Dec-13 Sep-13 Jun-13 Mar-13 Dec-12 Number of Customers K & Q 57,416 50,532 Cumulative # of Customers per: June 10-Q 64,411 47,079 September 10-Q 82,235 48,419 December K 83,265 13

14 Client Services + 1 (212) cservices@cfraresearch.com The content of this report and the opinions expressed within are those of CFRA. This analysis has not been submitted to, nor received approval from, the United States Securities and Exchange Commission or any other regulatory body. While CFRA exercised due care in compiling this analysis, CFRA AND ALL RELATED ENTITIES SPECIFICALLY DISCLAIM ALL WARRANTIES, EXPRESS OR IMPLIED, regarding the accuracy, completeness or usefulness of this information and assumes no liability with respect to the consequences of relying on this information for investment or other purposes. In particular, the research provided is not intended to constitute an offer, solicitation or advice to buy or sell securities. CFRA s financial data provider for financial companies is SNL FINANCIAL LC. CONTAINS COPYRIGHTED AND TRADE SECRET MATERIAL DISTRIBUTED UNDER LICENSE FROM SNL. FOR RECIPIENT S INTERNAL USE ONLY CFRA, CFRA Accounting Lens, CFRA Legal Edge, CFRA Score, and all other CFRA product names are the trademarks, registered trademarks, or service marks of CFRA or its affiliates in the United States and other jurisdictions. CFRA Score may be protected by U.S. Patent No. 7,974,894 and/or other patents. If you have any comments or questions, please contact cservices@cfraresearch.com 14