For over three months, First Solar (FSLR) has benefited from a lack of bad news. When FLSR announced on August 30th that it would halt deliveries of solar panels to its massive Agua Caliente project, the stock tanked 18.7% in one day, ending a sharp rally ignited by earnings on August 1st. Construction at Agua Caliente was way ahead of schedule and the palpable concern at the time was that FSLR had pulled forward a lot of panel demand from future years into 2012 to meet near-term revenue and earnings targets.
When I wrote three weeks later that FSLR's rally was losing momentum, I figured that the stock would soon experience follow-through to that selling. It took another two weeks for the stock to trade back down to levels from August 30th, but the stock has yet to look back since.
Since the post-earnings break out in early August, the 50-day moving average (DMA) has held as solid support for FSLR. For example, a post-earnings decline on November 2nd ended promptly at the 50DMA (an 8.9% loss on the day). FSLR's rally continued from there.
First Solar breaks out
The chart above shows that the 50-day moving average (DMA) has served FSLR well as support since the summer. When the stock broke above the 200DMA in mid-October, it was the first time FSLR had traded above that critical resistance since early 2011 when the stock was trading around $140. Although the stock is now barely trading at $30, it is breaking out in what has become a strong counter-trend rally.
First Solar bears finally started backing off First Solar in mid-August, likely contributing somewhat to the stock's steady push higher. However, the last time shares short dipped significantly in FSLR was in mid-February - that was the end of a short but strong rally that began at near four year lows in December 2011. Short interest in FSLR remains an incredibly lofty 51.5% of the float - a powder-keg waiting to explode one way or another.
After hitting multi-year highs in mid-August, shares short in FSLR have dipped significantly for the first time since mid-February
Source: NASDAQ.com short interest
With handwringing over Agua Caliente apparently left in the past, I took particular interest on November 15th when respected Maxim Group analyst Aaron Chew used FSLR's last 10Q report to estimate that 2013 EPS and margin guidance will disappoint. Here is the summary from his (corrected) report titled "FSLR - Lowering Estimates with Pipeline Revenue Balance Confirming New System ASPs <$2.00/W and Gross Margins ~15%":
In FSLR's 3Q12 10-Q, we find further evidence of system pricing trending <$2.00/W that suggests margins and EPS are headed lower. With $5.3b in revenue expected from its 1.4 GW-AC pipeline balance, we estimate 50% of the project MWs were sold <$2.00/W. With higher ASP projects likely to fall from ~50% of shipments in 2012 to 36% in 2013 and 21% in 2014, we expect gross margins to come under pressure and for FSLR to guide to a decline in EPS Y/Y in 2013. We lower our estimates accordingly and maintain our Sell.
During the last earnings conference call, FSLR answered a pipeline-related question by stating that the company has recognized revenue on 626MW of its 3GW pipeline. I found it telling that no analyst directly asked about Agua Caliente. Instead, analysts were trying to get a handle on things like FSLR's international mix of business, competition, margins, and the bankability of the backlog.
Chew points to data from tables on page 52 ("Projects Sold/Under Contract") of the 10Q which FSLR explains as follows:
The following tables summarize, as of October 31, 2012, our approximately 3.0 GW AC systems business advanced project pipeline. As of September 30, 2012, for the Projects Sold/ Under Contract in our project pipeline of approximately 2.0 GW AC, we have recognized revenue with respect to the equivalent of approximately 626 MW AC. Such MW AC equivalent amount refers to the ratio of revenue recognized for the Projects Sold/ Under Contract in our project pipeline compared to total contracted revenue for such projects, multiplied by the total MW AC for such projects. The remaining revenue to be recognized subsequent to September 30, 2012 for the projects sold/under contract in our project pipeline is expected to be approximately $5.3 billion . Such amount is expected to be recognized as revenue through the substantial completion dates of the projects sold/ under contract. Projects are removed from our project pipeline tables below once we have completed construction and after substantially all revenue has been recognized.
Chew estimates that the $5.3B remaining for revenue recognition will end up getting sold for less than $2.00/W ASP which is in-line with the $1.85/W ASP disclosed for First Solar's 20 MW-AC project in New Mexico for PNM Resources, Inc. Using gross margin assumptions for third-party module sales of about 10% and for new projects about 15%, Chew generates EPS estimates of $3.72 for 2013 and $2.45 for 2014. Based on these estimates, he reiterates a Sell rating and a $9 price target.
At FSLR's current price of $29.91, these EPS estimates give forward P/Es of 8.0 for 2013 and 12.2 for 2014. FSLR's current price-to-sales and price-to-book ratios are both under 1 - 0.91 and 0.77, respectively - so I prefer to think of FSLR as roughly fairly valued at current levels. I can accept a $9 worst case downside target for a phase when sentiment again turns against solar and First Solar in particular.
I remain comfortable with my earlier assessments that FSLR is for now just a trading stock and that the best way to play the longer-term survival of the company is to sell long-term puts, aka LEAPS, (articles written in August and March, respectively). The three-year pipeline of major projects should provide a solid floor of support for the business and a basis from which to execute trades. Selling puts after sell-offs where implied volatility spikes higher and premiums rise is a way of betting on the eventuality of a strong rally to follow without worrying so much about the exact timing, duration, or strength of the rally (for example, the current rally has come much sooner than I expected). FSLR's valuation is finally low enough and bearishness is high enough (at least earlier this year) to make the potential rewards of such a strategy worth the risks.
After scanning through the 10Q numbers that Chew used in his report, I decided to review the entire release. I did not find any smoking guns, but I did find some nuggets of interest that expanded upon info from the conference call. I quote these below with a little additional commentary.
First Solar is fully aware of the on-going risks in the solar business that promise to linger for quite some time. First Solar's Long Term Strategic Plan (LTSP) attempts to address this by focusing on emerging markets and "sustainable markets" - defined as markets with "an immediate need for mass-scale PV electricity" - where the company can sell "utility scale PV solar power solutions" using their modules.
The solar industry continues to experience a challenging environment, categorized by intense pricing competition, bankruptcies of several solar companies (particularly module manufacturers) and many solar companies generating little or no operating income. In the aggregate, manufacturers of solar modules and cells have installed production capacity that significantly exceeds global demand. We believe this structural imbalance between supply and demand (i.e., where production capacity significantly exceeds current global demand) may continue for the foreseeable future, and we expect it will continue to put pressure on pricing and our results of operations through the remainder of 2012. We further believe that this structural imbalance will remain unfavorable for solar companies that are primarily module manufacturers, but that companies with established expertise and meaningful solutions in other areas of the solar value chain, such as project development, EPC capabilities, and O&M services, are more likely to develop economically sustainable businesses.
First Solar is acutely aware of the on-going pricing pressures:
Over time, declining average selling prices are consistent with the erosion of one of the primary historical constraints to widespread solar market penetration, namely its affordability. In the near term, however, in light of continually declining FiT structures in the European markets and increased industry-wide manufacturing capacity, it is uncertain whether growing demand from other countries and markets can absorb industry-wide module supply without further inventory build-up and/or price reductions, which could adversely affect our results of operations.
The company is pinning its hopes on utility-scale projects to protect the business from the most extreme pricing pressures:
We continue to mitigate this uncertainty in part by executing on and building our utility-scale systems pipeline as a buffer against demand fluctuations…we have reduced our manufacturing capacity and planned solar module production levels, to match expected market demand, which considers our systems project pipeline. This decrease in planned production reduces our risk and the impact on liquidity of having excess solar module inventories that we must sell to third parties as we execute our Long Term Strategic Plan and respond to market pricing uncertainties for solar modules.
The reduction in capacity will cost FSLR:
We decided not to proceed with our previously announced 4-line plant in Vietnam and are attempting to sell the plant. We expect to complete the sale of the Vietnam plant within the next year, but the expected selling price is substantially below our cost of construction. We also plan to sell our Frankfurt (Oder) plants after we stop production at the end of 2012. We do not currently have an expectation on the timing of the sale of the Frankfurt (Oder) plants, but the expected selling price is substantially below our cost of the plants prior to impairment.
Despite these expected costs, rationalizing the business towards utility-scale systems helped to turn around cash flows in 2012. In the first 9 months of this year, FSLR was able to generate $434,650 net cash from operating activities; last year, it was negative (-$44,197). These results occurred even as component sales plummeted:
Components segment net sales decreased by 53% in the nine months ended September 30, 2012 compared with the nine months ended September 30, 2011 , primarily due to a 79% decrease in volume and a 34% decrease in the average selling price of modules sold to third parties, partially offset by a 95% increase in module net sales for modules used in our systems projects. The 95% increase in net sales for modules used in our systems business was primarily related to our Copper Mountain 2, AV Solar Ranch One, Silver State North and Topaz projects, partially offset by decreases in net sales from our Agua Caliente project.
While FSLR's stock is likely to move up and down over a wide range based on sentiment toward the solar industry and macro-economic events in countries which are major buyers of solar, the utility-scale business should generate the major trading pivot going forward. Traders should expect some of the most dramatic movements to occur whenever FSLR experiences setbacks or surprise successes at any one of its four major North American projects. For the next three years, First Solar's business will heavily rely on these projects:
We expect a substantial portion of our consolidated net sales, operating income and cash flows through 2015 to be derived from the following four projects in North America, which will be among the world's four largest solar PV power plants: the 550 MW AC Desert Sunlight Solar Farm, located west of Blythe, California; the 550 MW AC Topaz Solar Farm, located in San Luis Obispo County, California; the 290 MW AC Agua Caliente project located in Yuma County, Arizona; and the 230 MW AC AVSR1 project, located just north of Los Angeles, California.
This concentration implies that traders should be able to identify issues and opportunities with FSLR's business relatively quickly. Also note that perceived setbacks in this utility-scale business could cause out-sized drawdowns on the stock. Trade accordingly.
Be careful out there!
Additional disclosure: I am long in FSLR through puts sold short. I am also long calls and puts.