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First Solar, Inc. (NASDAQ:FSLR)

F4Q08 Earnings Call

February 24, 2009 4:30 pm ET

Executives

Larry Polizzotto – Vice President of Investor Relations

Michael J. Ahearn – Chief Executive Officer

Jens Meyerhoff – Chief Financial Officer

Bruce Sohn – President

Analysts

Vishal Shah - Barclays Capital

Steve O'Rourke - Deutsche Bank Securities

Nick Allen - Morgan Stanley

Mark Bachman - Pacific Crest Securities

Sanjay Shrestha - Lazard Capital Markets

Satya Kumar - Credit Suisse

Robert Stone - Cowen & Company

Jesse Pichel - Piper Jaffray

Kelly Dougherty - Macquarie Research Equities

Stephen Chin - UBS

Daniel Ries - Collins Stewart LLC

[Jed Gorshire] – Canaccord Adams

Colin Rusch - Broadpoint AmTech

Operator

Good day ladies and gentlemen and welcome to the First Solar fourth quarter 2008 earnings conference call. This call is being webcast live on the Investor’s section of First Solar’s website at www.firstsolar.com. (Operator Instructions) As a reminder, today’s call is being recorded.

I would now like to turn the call over to Mr. Larry Polizzotto, Vice President of Investor Relations for First Solar. Mr. Polizzotto, you may begin.

Larry Polizzotto

Thank you. Good afternoon everyone and thank you for joining us for First Solar’s fiscal fourth quarter 2008 conference call. Today after the market closed, the company issued a press release announcing its fiscal fourth quarter 2008 results and financial results for 2008. If you did not receive a copy of the press release you may obtain one from the Investors section of First Solar’s website at firstsolar.com.

In addition, we have posted key quarter statistics and financial historical data and operating performance on the IR website. An audio replay of the conference call will also be available approximately two hours after the conclusion of the call. The audio replay will remain available until Friday, February 26, 2009 at 9:59 PM Mountain Standard Time, 11:59 PM Eastern Daylight Time; and can be accessed by dialing 888-266-2081 if you’re calling from the United States; or 703-925-2533 if you’re calling from outside the United States and entering access ID number 1325337.

A replay of the webcast will be available for 90 calendar days approximately two hours after the conclusion of this call. Investors may access the webcast on the Investors section of the company’s website at firstsolar.com. If you are a subscriber of Factset you can obtain a written transcript within two hours.

With me today are Mike Ahearn, Chief Executive Officer; Jens Meyerhoff, Chief Financial Officer; and Bruce Sohn, President of First Solar. Mike will begin with an overview of the company’s fourth quarter and fiscal year 2008 achievements, followed by a market and overall business update. Jens will provide you with the fourth quarter 2008 financial results and provide an update to guidance for 2009. We will then open up the call for questions.

I want to remind you that all numbers reported and discussed in today’s call are based on general accepted accounting principles. The company has allocated approximately one hour for today’s call. During the Q&A period as a courtesy to those individuals seeking to ask questions, we ask that participants limit themselves to one question and one follow-up question.

Now I’d like to make a brief statement regarding the forward-looking remarks that you may hear on today’s call. During the course of this call the company will make projections and other comments that are forward-looking statements within the meanings of the Federal Securities laws.

The forward-looking statements in this call are based on current information and expectations, are subject to uncertainties and changes in circumstances; and do not constitute guarantees of future performance. These statements involve a number of factors that could cause actual results to differ materially from these statements including the risks as described in the company’s most recent annual report on Form 10-K and other filings with the Securities and Exchange Commission. First Solar assumes no obligation to update any forward-looking information contained in this call or with respect to the announcements described herein.

Before I turn the call over to Mike Ahearn, I’d like to mention that during the first calendar quarter of 2009 the company will be attending the following conferences; Canaccord Adams Sustainability Forum in Deer Valley, Utah on February 26, 2009; Morgan Stanley’s Technology Conference in San Francisco, March 7, 2009; Photon’s 4th Photovoltaic Technology Show in Munich on March 5, 2009; Merrill Lynch Clean Technology Conference in New York City on March 11, 2009; and finally, Oppenheimer’s Alternate Energy Conference in New York City on March 12, 2009.

It’s now my pleasure to introduce Mike Ahearn, CEO of First Solar. Mike.

Michael J. Ahearn

Thank you Larry. Thank you for participating in First Solar’s fourth quarter 2008 earnings call. As you saw from the release, First Solar had another strong quarter in Q4. Jens will provide some of the financial details on the quarter but I’d like to make a start by hitting a few of the highlights.

Fourth quarter production was 173.6 megawatts. That’s up 27% sequentially bringing our total 2008 production to 504 megawatts. Net sales for the fourth quarter were $433.7 million. That’s up 24.4% quarter over quarter, resulting in net income of $132.8 million or $1.61 per diluted share. For the year we achieved $1.2 billion in net sales, up 147% and EPS of $4.24 per diluted share.

We achieved our 2008 goals in the U.S. utility industry by constructing a 10 megawatt AC ground mounted PV plant near Boulder City, Nevada in less than five months for Semper Energy; by securing three large rooftop projects with Southern California Edison to demonstrate First Solar’s low-cost rooftop solution; and then by establishing a development relationship with Edison Mission Energy an associate of Southern California Edison.

And finally we reduced factoring costs to $0.98 a watt in Q4. That’s down 9% quarter over quarter and 12% for the year. Breaking that $1 per watt benchmark is a major industry milestone. It’s something the industry has been chasing for 20 years and I’d like to take a few minutes before we get back to the normal flow to put our accomplishments over the past few years in perspective.

First Solar increased its annual production from 20 megawatts in 2005 to over 500 megawatts in 2008, which is a 25 fold increase over the four year period. In 2009 our production capacity will double to a little over 1 gigawatt. That means we’ll be able to produce the equivalent of an average sized nuclear plant every year.

With the right market structures in place, we’re capable of significantly expanding our annual production capacity beyond these current levels. During this scale up, manufacturing costs declined by two-thirds from $3 a watt at the end of 2004, which has been roughly the historic level of PV manufacturing costs to less than $1 a watt today.

We’re capable of further significant cost reductions based on the yet untapped potential of our technology and manufacturing processes. In fact, the long term financial models we have previously discussed suggest manufacturing cost targets of $0.65 to $0.70 a watt by 2012. We picked those as interim milestones as you know to drive the business, but we believe reductions below these levels are clearly possible beyond that timeframe.

In 2009 we expect to surpass one gigawatt of total installed solar powered systems, demonstrating the reliability of our technology on a large scale and under a wide variety of operating conditions. And we have clearly been an engine of economic growth in the communities where we operate over this time period, creating roughly 4,000 direct new jobs and thousands of additional jobs throughout our value chain.

These results demonstrate to me at least two things. First, under the right market structures like we’ve had in Germany and elsewhere in Europe, solar power is capable of dramatic cost reduction and scale over very short periods of time. I think we’ve proved that. Second, based on the results to date and the improvement trajectories, its apparent solar power will be capable of delivering the economics and the performance needed to be an integral part of the low carbon energy infrastructure that we’re moving toward over the next several years.

Market structures that enable cost effective scale are the key to continued progress for First Solar and the rest of the solar industry. And over the mid-term, let’s say three to five years out and beyond, the market outlook for solar power has never been better.

And I say this for several reasons. A global consensus has now been reached on the need to take action and to mitigate climate change. And significantly, different from any time in the history of this industry, this now includes the U.S. which through the current administration and congressional leadership has signaled an intention to work with other industrialized countries on the next round of carbon reduction negotiations and to create a federal mechanism for pricing the external costs of carbon dioxide emissions into the marketplace.

The dramatic reductions in greenhouse gas emissions that will be necessary to prevent catastrophic climate change will require a fundamental reshaping of our global energy infrastructure which will create a prominent role for renewable energy and solar power in particular, due to the wide availability of solar resource and the versatility of solar applications. In recognition of the role that renewable and solar will play in the coming low carbon energy infrastructure, and the need to immediately develop and scale the enabling technologies, the EU recently reinforced its commitment to renewable energy with an EU-wide directive that commits the EU to 20% renewable energy targets by 2020.

As you know, the U.S. recently passed a stimulus bill which is designed to accelerate the deployment of renewable energy and we believe a broader energy bill will be considered shortly that builds on these interim measures. When you add these public policy initiatives to the dramatic cost reductions that are currently underway, a very attractive picture emerges for the future of the industry.

Which brings us to the paradox which is that as good as things look for the mid-term and beyond, the short-term outlook for the solar industry in our view has never looked more difficult. Since our last earnings call, members of our management team have spent significant time in Europe meeting with customers, politicians, project investors and banks in all of our G-markets. Our ongoing work only confirms that the solar industry like most everyone else is being impacted by the global financial crisis that we’ve entered.

Now let me share a few perspectives from the recent meetings that a number of us have had. Bank lending continues to be slow in almost all markets, although availability has marginally improved in Q1 compared to Q4 of 2008. For example, in Germany where the KFW program is supporting lending activity we’ve seen willingness of banks to entertain highly creditworthy club type deals, where a number of banks work together to provide the facility.

We’ve also seen smaller local German banks become more active around these projects and they’ve indicated lending capability due to their limited exposure to bad debt. Overall, however, they have stepped back [inaudible] and the global banking system remains fragile and credit remains more expensive than pre-crisis levels.

Our hope is that further government support will bridge project lending until total normal lending patterns resume. The Department of Energy’s long term guarantee program under the recent stimulus bill is a good example. There are also a few quasi-government agencies in Europe that are actively considering various forms of credit support for solar projects.

Equity financing in solar projects ranging from building owners that purchase systems for their rooftops to institutional project investors is continuing but its become less predictable and in some cases more expensive than before the crisis ensued. In particular, we’re seeing larger, more sophisticated investors take an opportunistic approach to maximizing investor returns and this is causing them to compare solar project returns to other investment alternatives that provide higher yields and/or better liquidity.

As a result of these dynamics, a couple of things are happening to the fundamentals of the business model. Project pipelines are more uncertain than before, both in terms of realization and timing, which makes short-term results less predictable. And as stated in our last call, project finance costs are higher than before, putting downward pressure on its [goal] systems and module prices.

These conditions are pressuring the entire solar value chain, equipment suppliers, module manufacturers, as well as project developers, system integrators and distributors and as an example we mentioned on our last earnings call that although First Solar generally enjoyed a strong customer base, we consider a small number of our customers to be under financial stress. We currently believe the potential customer defaults translate to roughly 10 to 15% of 2009 volumes.

The downward pressure on module prices is exacerbated by module over supplies. Although our information in this regard is anecdotal, we’re fairly confident in confirming some of the reports that are out there that excess inventories of crystal and silicon modules were shipped over Q4, which are now resulting in lower pricing and generous extensions of payment terms in some cases.

I should point out that First Solar has not encountered any direct price competition as a result of these over supply conditions. In addition, we do see signs of production curtailment among some manufacturers and some market resistance to products with unproven quality into companies with unproven capabilities. But the bottom line is whether over supplies continue through 2009 and the impact of any over supplies on pricing in general and First Solar in particular remain to be seen, we regard over supply as a risk that we need to continue to monitor very closely.

In the U.S. the grant program under the stimulus bill will allow us to monetize the ITC. This is a tremendous help. However, the net cost of solar projects that the 70% remaining after the 30% grant still has to be financed. As I mentioned, the loan guarantee program administered by the DOE will be important in stimulating debt financing in the U.S.

We do expect the stimulus bill to expand the U.S. market, but it likely will not result in a significant change in volumes of utility scale deployment in 2009. And that’s true for several reasons. The final project approval timelines on larger utility scale projects are lengthy. They would extend beyond typically a 2009 cycle. The tight credit markets have driven utilities to reduce spending on renewable energy projects. And we also believe the combination of low natural gas prices and fiscal distress could make many states unwilling to step up and subsidize large volumes of solar projects at least over the short term.

So where does this leave First Solar? As we consider the challenging environment, First Solar has a number of strengths that we can leverage; low cost production which we will continue to drive through technology development and operational excellence; a strong liquid balance sheet; a customer base in Europe that we consider on the whole to be the strongest in the industry for the types of markets that we serve; an EPC capability in the U.S. with a proven ability to deploy projects quickly and economically; a strong market position in Germany, which is the core market in the solar industry today.

In that regard, our discussions with German officials over the past few weeks have confirmed Germany’s continued support of the solar industry for the 2009-10 period. Strong customer positioning in Italy and Europe, which we believe are the other two EU markets that will emerge in volume over 2009 and ’10; and a growing set of quality relationships in the U.S. utility industry that we hope will translate to large, long-term utility scale projects.

We’re working on several initiatives that will utilize these strengths to further build the long-term value of our business during 2009. First, as we demonstrated and discussed in the past, we are willing to lower prices in return for higher volumes and more certain demand, provided we earn our targeted return on capital. We’re currently pursuing opportunities to reduce module pricing on a selected basis where we believe lower prices may enable higher throughput.

As Jens will describe further, we do not envision that these price reductions would cause us to alter our previous revenue guidance for 2009 and we continue to operate within the RONA threshold we previously discussed.

Second, we’re pursuing opportunities to alleviate project financing uncertainties by co-investing in selected large scale projects. The full nature and extent of our financing activities are not yet defined, but we expect to co-invest at rates of return that enable us to operate within the RONA thresholds that we previously described. We are making certain assumptions in our guidance based on the timing of revenue recognition for these financed projects which Jens will also describe to you.

Third, we’re extending the payment terms for a number of our customers that currently have ten day payment terms to 45 days. This will provide our customers with important flexibility to deploy funds towards project development and realization, rather than tying up their funds for working capital during this time of heightened uncertainty and credit difficulty.

As of today we’re continuing to ramp the balance of our KLN production capacity and to operate at full production capacity in all of our factories in the belief that we can sell all product we’re capable of producing in 2009. Now in taking this approach, we’re cognizant of two risks posed by the uncertainties in the marketplace.

First we’re exposed to a timing risk, meaning a risk that project timelines could slip from period to period, causing First Solar to build inventories that on a temporary basis could be larger than normal at various times throughout 2009. Second, we could be exposed to an over supply risk, meaning that First Solar could produce more than could be sold into the market, forcing us to curtail production or drastically reduce prices to clear the market. We regard this latter risk as serious and we plan to remain extremely vigilant with regard to over supply conditions and excess inventory, and to take prompt steps to minimize negative financial consequences should this situation develop.

So in summary, we’re focused on maintaining market operating and financial momentum throughout the short term so that we’re in the best position possible to maximize the tremendous opportunities we see over the mid and long term. At the same time, we’re cognizant of the dynamic and challenging environment and we’ll remain vigilant and proactive.

With that I’d like to turn the call over to Jens.

Jens Meyerhoff

Thank you Mike and good afternoon. Net sales for the fourth quarter were $433.7 million, an increase of 24.4% over the third quarter of 2008. The increase was primarily driven by continued strong demand, supported by the ramp of Plant 1 and 2 in Malaysia, and higher line efficiency partially offset by currency fluctuations as the euro declined sequentially from a blended $1.51 to $1.41 per euro during the quarter.

Manufacturing costs per watt for the fourth quarter were $0.98, down 9% quarter over quarter and 12% for the year. Cost per watt included $0.03 of Malaysian ramp costs and $0.02 of stock-based compensation expenses. Cost per watt is expected to continue to decline with the ramp of our remaining plants in Malaysia and continued throughput improvements.

Gross margin for the fourth quarter was 53.9%, down 2.1 percentage point quarter over quarter primarily due to unfavorable foreign exchange trends and customer mix, which was partially offset by lower manufacturing costs. Operating expense growth slowed further in the fourth quarter as we start to reach infrastructure scale in certain organizational areas. Operating expenses excluding production start-up costs were down 2.2 percentage points to 14.7% of net sales in the fourth quarter.

Plant start-up costs increased by $2.4 million sequentially to $8.8 million as Plant 3 in Malaysia commenced production during the quarter and we continued to incur start-up expenses for both Plant 3 and 4.

Operating income for the fourth quarter was $161.3 million or 77.2% of net sales and included $15.3 million of stock-based compensation expenses. The fourth quarter continued to strong underlying operating leverage in our business model.

Net income for the fourth quarter was $132.8 million or $1.61 per share on a fully diluted basis and included $4.2 million of interest income and $6.2 million in foreign exchange gains and a tax rate of 22.6%. Cash and all other marketable securities increased by $92.4 million to $821.8 million in the fourth quarter. We generated $74.6 million of free cash flow in the fourth quarter and $3.8 million of free [set] cash flows for the year, while continuing to fund high levels of growth.

Cash flow from operations during the fourth quarter was $203.3 million driven by continued revenue growth. In the first and second quarter of 2009, cash flows will be impacted unfavorably by a total of approximately $140 million due to the change in our payment terms.

We spent $128.7 million for capital equipment during the fourth quarter against depreciation of $20.4 million. Return on net assets for the fiscal year 2008 was 22.4%. We have communicated in the past that at scale this metric does not correlate to our current gross margin performance which has benefited in addition to our industry leading manufacturing costs, from high subsidies; payroll exchange rates; and pricing.

Our strategy is to leverage our cost leadership to drive market growth and expansion. This includes trade offs in pricing in order to drive higher demand and cash throughput for the company, even though margin percentages may decline. We’d like to remind our investors that we continuously assess any constraints around throughput and drive for its optimization rather than managing to unsustainable margin targets.

Before I get to the specific guidance for 2009, I would like to explain the underlying assumptions and potential risks. As Mike mentioned earlier, we have identified approximately 10 to 15% of potential customer default risk. While we’re monitoring the situation and are working to reallocate these volumes if needed, we could see some inventory build in the first half of 2009.

Over the past weeks we have started to engage in the financing of a large scale, German project by co-investing capital and directly engaging in the negotiations structuring of long term debt financing. This co-investing activity will reduce 2009 revenue recognition beginning in the first quarter of 2009 in exchange for a 20 year annuity stream over the term of the feed-in tariff.

Our investment decision around these opportunities are guided by our long term RONA growth. For 2009, 48% of our expected net sales are hedged at an average rate of $1.37 per euro. In addition, our national hedges bring the net income hedge ratio to 58% for 2009. Since we layer our hedges net income for Q1 and Q2 2009 are hedged at 75% compared to 60% for the second half of 2009. We assume an average exchange rate of $1.15 per euro for the unhedged portion of our 2009 guidance, bringing the average euro exchange rate to $1.26 per euro for 2009.

For the remainder of 2009 the $0.01 euro fluctuation impacts our net sales by approximately $8 million and our operating income by approximately $6 million. The range of our guidance does not provide for different scenarios in the financing environment beyond the parameters known today due to the inherent lack of their predictability. If market uncertainties continue to increase, particularly around financing, we could reach a point at which in our opinion continued guidance would provide little useful information to our investors.

With that, let me provide you with an update to our 2009 guidance. We are maintaining our previous net sales guidance with the exception of up to $200 million of revenue deferral for co-investing equity in PV projects, bringing our GAAP net sales guidance to $1.8 to $1.9 billion. Q1 revenues could be flat to slightly down due to changes in pricing; lack of Q4 financing flow; revenue deferral; and a sequentially weaker euro.

We expect plant start up costs of $13 to $14 million for 2009. Stock-based compensation is estimated at $75 to $80 million with approximately 20% allocated to cost of goods sold. GAAP operating margin is expected between 33 and 34% of net sales, subject to net sales in line with previous guidance.

We expect our 2009 tax rate to be between 9 and 11%. We also expect to record a one time, Q1 tax benefit of approximately $11.6 million related to the reversal of our 2008 Malaysian tax expenses as a result of receiving full approval to pull our Malaysian tax holiday into 2008.

Year-end 2009 fully diluted share count guidance is an estimated 84 million shares. CapEx for the year is expected to be $270 to $300 million for investments and completion of Malaysia Plants 3 and 4, our Ohio expansion and other infrastructure needs. We expect to remain free cash flow positive in 2009.

This concludes our prepared remarks and we would like to open the call for questions. Operator.

Question-and-Answer Session

Operator

Thank you sir. (Operator Instructions) Your first question comes from Vishal Shah - Barclays Capital.

Vishal Shah - Barclays Capital

Mike, you mentioned your long term operating model has 25% operating margins. When do you expect your – you know to reach that kind of long term model? Will that be 2012 timeframe or would you imagine that to be you know earlier than that? Can you give us some color on that? And then as far as your customer contract renegotiations are concerned, are you looking at 2010 and are you sort of looking at pricing as you look at the industry right now? How are your, you know, discussions with customers going?

Michael J. Ahearn

Let me – I can speak to the pricing for a minute and then maybe Jens can talk about the financial model. There’s a couple of angles on the pricing we’re looking at Vishal. One is where do we see opportunities to open new markets that traditionally have not been heavily subsidized at least with PV type subsidies, or served by the PV industry. And we do believe there are opportunities there and demand is price elastic.

The other would be, you know, even in existing subsidy markets where do we see specific opportunities to drive throughput at higher rates and with more certainty to offset some of the higher costs of project financing. So the discussions we’re having with customers are on a selective basis around specific market opportunities and market segments, [inaudible] to some sort of a wholesale type of a reduction.

As far as the long term financial model, maybe you want to address that, Jens.

Jens Meyerhoff

Yes. Certainly. So Vishal as you may recall so actually the 25% long term operating margin target has to be seen in line with the 20% RONA goal. I gauge it today a RONA number of 22.4% right around operating margins that were in excess of 30% which would imply by continued requirement to scale the business and to grow, so therefore I think this remains a long term model. It’s always been a long term model that we kind of more model around the grid parity goals of 2010 towards 2012.

Operator

Your next question comes from Steve O'Rourke - Deutsche Bank Securities.

Steve O'Rourke - Deutsche Bank Securities

First is there a duration in the change in the payment terms? That is, will it revert to prior terms after a set number of months or is it kind of open-ended? And second question, your CapEx guidance is a bit down from the guidance you gave last quarter and it sounds like what you’re doing is roughly the same. Can you account for the difference there for us?

Jens Meyerhoff

So yes so the payment terms we actually see the change in the payment terms for 45 days as permanent. And maybe just to give a little bit of backdrop, we implemented into two to ten day payment terms as a private company, right, when the working capital constraints essentially was with that and when we’re managing very rapid growth. Today in the current market we do not believe that ten day payment terms actually fosters throughput in the system because it eventually creates a constraint to our customer where it takes liquidity away from them that they require to develop and deploy systems.

If you look at the CapEx guidance the one thing generally I would say the general scope in the CapEx guidance with respect to the remaining capacity expansions obviously haven’t changed. However what we have done given the overall economic times we’ve scrapped overspending, we’ve scrapped our CapEx as probably every company would do in these times, and there’s after all a slight reduction on the CapEx side.

Operator

Your next question comes from Nick Allen - Morgan Stanley.

Nick Allen - Morgan Stanley

Can you talk a little bit about the breakdown of sales for the quarter between components and systems? And then also it looks like there was a run rate in the line – a decline in the line run rate. Can you talk about that as well?

Jens Meyerhoff

So I think if you think about it, I don’t think historically we’ve really broken down the sales on the components and on the systems side. What I can tell you is we obviously had revenue recognition of all the El Dorado project that we’ve brought it on in Q4. Essentially it came all through mostly in Q4. Again refer to the second footnote that we’re going to publish a little bit later in our 10-K. I’ll hand the question on the throughput side to Bruce.

Bruce Sohn

The throughput for the quarter was about 47.7 megawatts per line which is down slightly as you observed which really just reflects the variation that we’re seeing as we bring on the additional capacity in Malaysia and the ongoing development work in Perrysburg. As the lines come up and the proficiency of the operators and engineers develops, we expect the run rates to match. From an efficiency and a quality perspective, the performance of those lines are statistically matched to our other factories, consistent with our [inaudible] technology.

Operator

Your next question comes from Mark Bachman - Pacific Crest Securities.

Mark Bachman - Pacific Crest Securities

Jens, I’m hoping that you can talk to us a little bit more about this investment in Germany, maybe talk to us about the size of the project. I know you mentioned long term debt. It sounds like because of revenue recognition you might have taken an equity stake in this, so if you can kind of talk to your investors as to how you use your balance sheet, that would be appreciated.

Second question is I just wanted to make sure is there any coincidence today between the timing of your call being pushed today and the announcement that we saw out of PG&E of the 500 megawatt PV project by them? And then lastly, Bruce, just on that line count, can you just verify that there was no problems with the line this quarter? It seems like that that number should be increasing especially as efficiency increased there. And I know that I think you had a couple of down days around the holidays, but I just want to make sure that there was no manufacturing problems around or that accounts for that line being down.

Jens Meyerhoff

Okay. Well, that’s a handful here, Mark, so I’m going to take your question one and Mike will maybe talk about the – I mean the short answer to the timing of the call has nothing to do with anybody’s announcement, the way we timed the call, to give you a little more color.

So the specific project we started to participate in and from an equity investment point of view has not yet been announced by name. It is a very large installation for Europe’s sake. And if you think about the impact right now, we’re conservative about how we model and substantially have modeled that we essentially hold the equity piece in it. As the project is significant de-levered right now, we do have banking approval out of all participating financing banks at this point in time. And bringing the project to a leverage above 80% which limits obviously the equity side of the capital commitment to the project.

Now obviously from a pure accounting point of view since we own and operate for all practical purposes that plant into the future, unless we decide to do something else with it, you won’t essentially capitalize that project straight onto your balance sheet. So this is not comparable as a flip structure accounting you use out of the U.S. This will actually show up as an asset on our balance sheet and then provide returns coming on an annual basis, coming out of the 20 year feed-in tariff.

Bruce Sohn

In regards to the lines, you did identify of course the holidays that do occur during Q4, different factories, different countries, based on their local customs and cultures. But in terms of operational, the challenge is always just bringing up the factory and developing the proficiency.

You’ll recall as we bring a new factory on line like a KOM 2 or a KOM 3 each of these factories is bringing online capacity in the neighborhood of about 190 megawatts, 170 megawatts or so of total capacity. That’s significant capacity and our expectation is to start up matched from an efficiency perspective, matched from a yield perspective and matched of course from a quality and a liability perspective.

And so we’re very cautious and careful and have a high degree of expectation in terms of the way we operate the factories. As the proficiency of the workers develops, the run rate itself will also match.

Operator

Your next question comes from Sanjay Shrestha - Lazard Capital Markets.

Sanjay Shrestha - Lazard Capital Markets

Just a quick point of clarification. When you talk about this 10 to 15% potential risk that you might have to reallocate and then talk about the co-equity investment doesn’t that take into consideration sort of the adjustment to the top line guidance for 2009?

Jens Meyerhoff

Yes. Essentially that’s why we state it. I mean essentially we said that if you look at the guidance, the guidance essentially is consistent to the prior guidance except essentially the accounting treatment of the equity investment portion into selected projects. So as you look at the 10 to 15% customer [inaudible] we mentioned that default existed or the default risk on our last call. I think you should kind of think about right that we’ve been continuously working that. Actually I think we’ve been successfully reallocating some of the volumes into customers that are financially more viable, that have better access to financing and also that have a clearer pipeline visibility.

Operator

Your next question comes from Satya Kumar - Credit Suisse.

Satya Kumar - Credit Suisse

What are the inventories that you have at your customer sites and the channel? Do you have a sense of that? Did you sign any new contracts with customers in the last three months? Are the contract terms similar to the five year contract that you’ve signed in the past? And given that you’re investing in a large project it appears that you’re turning over equity for that but you’re not changing your revenue guidance. Does that mean that some of the volumes that you had in contracts to other customers is not going to be less than what you previously expected?

Jens Meyerhoff

I think with respect to inventories to customers that actually I think was a key topic during our trips. So as Mike mentioned we essentially visited all of our customers in Europe. We could not detect inventory levels that would be in excess of what we deem seasonal. Germany had a very cold winter which actually had slowed down installations. I don’t think we had detracted inventory levels that were at – could be described as highly elevated.

So from that perspective I think we came with the check mark out of this trip. You look at new contracts, yes we have signed new contracts. We haven’t announced any of these new contracts because we’re in the middle of negotiations still with contracts, and obviously with respect to the terms of these contracts they’re probably going to be left open to disclose detail terms because the competitive situation has increased significantly and we’re probably less interested in sharing that information, probably for those reasons.

So Satya you had a third question that honestly I tried to write down but I didn’t manage to get it all down. If you could repeat it one more time, please.

Satya Kumar - Credit Suisse

Essentially your revenue guidance was unchanged from before but does include $200 million. That sort of came off because of your investments in these projects.

Jens Meyerhoff

Yes.

Satya Kumar - Credit Suisse

Does that mean that some of the megawatts that you previously had allocated to customers on contract are coming off now?

Jens Meyerhoff

No, it doesn’t mean that they’re coming off. There were actually megawatts that may either not have been allocated or were allocated where we’re partnering together with customers, right, to realize these projects in which we take equity ownership. So it’s the same megawatts.

Operator

Your next question comes from Robert Stone - Cowen & Company.

Robert Stone - Cowen & Company

Jens, very good progress on the expense ratio. I wonder if you could just give us a little color on how to think about the progress you might make in that regard this year especially as the business will now start to involve some other activities like the project?

Jens Meyerhoff

Yes, as I mentioned we have organizations, right, that I think are starting to reach scale, right, and also saying going to be less investment sensitive. However as you mentioned, too, there’s other initiatives within the company, right, that are still growing, right, with respect to I think the systems business in the U.S., with respect for example some of these activities around project finance in Europe. However, we do expect to continue to see essentially scaling around our operating expenses. Obviously in these times we believe it’s prudent to have a close eye on our operating expenses and with respect to how we deploy such funds.

So I think you will see against the revenues continued scale, right, as we go through the year. Maybe not quite to the tune that you saw last year, right, because if you look at the quarter revenue deployment, right, you might not get quite the same type of revenue growth momentum. But you will still see scale.

Operator

Your next question comes from Jesse Pichel - Piper Jaffray.

Jesse Pichel - Piper Jaffray

When you talk about default, you’re talking about defaulting on a contract not defaulting on a receivable. Is that correct?

Jens Meyerhoff

That is correct.

Jesse Pichel - Piper Jaffray

And secondly going into this call you had 791 megawatt contracted for ’09. Was this large German project which you’re helping to finance already in that 791? Or is it in addition to the 791?

Jens Meyerhoff

No, it was not in addition.

Jesse Pichel - Piper Jaffray

And could you update us then on what the total backlog is for ’09?

Jens Meyerhoff

I would probably like to give you that update but as I mentioned we’re still in negotiation. I think it would probably make more sense to update the total number on the following quarter call.

Operator

Your next question comes from Kelly Dougherty - Macquarie Research Equities.

Kelly Dougherty - Macquarie Research Equities

I just want to follow up quickly on these equity investments. Should we just think of them as not your preferred alternative and just something you’re doing in light of current circumstances? And I guess what I’m trying to get at is, you know, if this will be an increasing ownership position going forward, if it’s the funding environment starts to improve?

Jens Meyerhoff

I actually would say that I think we’re in the early stages of this as Mike mentioned, right? And we’re evaluating it. I think you could definitely see this develop and so I’m not saying we won’t be doing longer term even absent of some of the near term crisis. But as I mentioned we’re doing one project right now to pilot and then based on that learning we are going to explore further activities and then we’ll be happy to update you on that progress.

Kelly Dougherty - Macquarie Research Equities

With your $0.65 to $0.70 per watt cost expectation could that be pulled ahead from 2012? I mean you’ve broken the $1 level. You’ve got increasing scale, lower Malaysian costs, conversion efficiency. I’m just wondering how we should think about the cadence of cost improvements over the next several quarters.

Jens Meyerhoff

Bruce, you want to take a [inaudible]?

Bruce Sohn

Yes, Kelly, I’d say that our ongoing improvement plans are really to continue to drive the efficiency that helps drive the costs down, drive the run rates of the factories, and then of course continuing to focus on the raw material costs as we purchase them. Continuing to scale facilities like our Malaysia operation helps significantly as we build out the line. And continuing to see the market develop certainly aids in our ability to drive down those costs, so we continue to stay focused on it. We think it’s a reasonable challenge for us to get there in this 2010 to 2012 timeframe.

Jens Meyerhoff

Kelly, if you look at it historically, right, I mean we’ve driven 10 to 12%. I think as of today we’ve probably slightly outperformed that roadmap, right, and we’ll continue to work quite hard to continue trying to meet these goals.

Operator

Your next question comes from Stephen Chin – UBS.

Stephen Chin – UBS

Just first a clarification again, did you pull out a production target for 2009 or are you still keeping it at 1.1 gigawatts? And secondly for Mike I think you talked about a willingness to lower prices to get higher volumes. What type of lower prices are we talking about? Are we talking about another 5 to 10% price discount versus the existing contract prices? And what kind of scale are you thinking of?

Jens Meyerhoff

Number one, so yes, that is correct. We maintained the 1.1 gigawatt outlook on the production side. I would say with respect to pricing, so you see that the pricing some of the pricing strategy was discussed today, right, didn’t really have any meaningful impact on the guidance, right, which would also suggest that we’ve been thinking about this for a while, but also that our costs have come down. I mean we achieved a very significant cost milestone. That actually enables us with more flexibility around the pricing and we’ve always stated that we will drive throughput.

Now with respect to how significant and what percentage is price declines are again I would deem that competitive information. I mean, right now we’re getting into a more demand driven environment where essentially I think we’d like to be a moving target on that and not necessarily disclosing our private strategy publicly.

Michael J. Ahearn

At least as of today we’re not seeing any price competition from [crystalline] so as far as driving any kind of price response on our part, we’re still operating a notch, maybe a couple of notches below where all that activity’s taking place. So this is more driven by opening new markets, or at least experimenting in heating new markets where we think we can hit a price point that the industry hasn’t been able to achieve and create some longer term growth.

So you’re not going to see a lot of volume in ’09 just because of the nature of opening new markets. It starts a lot smaller and builds if we’re successful with the initial round of experiments. I think the overriding way to look at it is we’re within the guidance, the previous guidance, certainly minimal in that respect.

Operator

Your next question comes from Daniel Ries - Collins Stewart LLC.

Daniel Ries - Collins Stewart LLC

The cost reductions seen in the quarter, would it be correct that Malaysia 2 coming online was the majority, but can you give us any color as to how much came from lower purchasing costs of glass and other components versus efficiency and throughput improvements?

Bruce Sohn

So obviously getting below $1 a watt, that’s a significant milestone and we’re really pleased with the organization’s ability to execute on that. And it’s really a combination of all of those that we don’t typically break out into detail, but as you know KOM 2 did come online and was running the entire quarter. We began shipping early in that quarter and that volume was quite significant.

In terms of the efficiency, it was up slightly over the year. The run rate was comparable as we talked about earlier, but the materials costs have also been coming down sequentially as well as we continue to scale the business. We like to work with suppliers that share our vision for lowering costs and provide a good high quality product and are willing to work with us to further scale the business and drive meaningful markets. And we’re able to find and work with more and more of those suppliers as the company continues to grow.

Daniel Ries - Collins Stewart LLC

I guess maybe my question was has the worldwide economy affected the availability and price of those components, particularly the glass?

Bruce Sohn

No, we’ve been in pretty good shape from a glass availability perspective. That has not been a significant issue for us.

Michael J. Ahearn

I guess on the flip side are we seeing a massive depression of prices. I would say the answer to that no at this point.

Operator

Your next question comes from [Jed Gorshire] – Canaccord Adams.

Jed Gorshire – Canaccord Adams

What was the conversion efficiency this quarter? And then I have a follow up.

Bruce Sohn

Ten-point-eight percent on the conversion efficiency.

Jed Gorshire – Canaccord Adams

My follow up relates to the cost structure and you’ve touched on it a little bit with a few of the previous questions, but as we look at your ability to drive down costs compared to crystalline systems, how much do you expect to come from upstream manufacturing efficiencies as it relates to either conversion efficiency or lower grams per watt of your raw materials? And how much do you expect to actually come from downstream going into selling more systems and then EPC?

Bruce Sohn

Well, so on the raw materials front, as you know our story we use a very small amount of our advanced [Intel] technology, we use a very small amount of semiconductor material. So that means there isn’t a significantly large component associated with it, so as the material changes upward or downward as the industry matures it doesn’t have a significant effect on it.

However, over time what we’ve talked about is that our expectation is to continue to drive the costs down to the $0.65 to $0.70 per watt range of which efficiency is in the neighborhood of about 15%; continuing to build out in low cost geographies is about another 15%; reducing the cost is about another 7%; and scaling the factories and increasing throughput is about another 5 to 7%. And so that’s kind of the roadmap that we’ve been on for the last couple of years and as Jens pointed out earlier, we believe we’re slightly ahead of that roadmap but we continue to drive continuous improvement throughout all elements there.

Now the advantage about efficiency, of course, is that as we drive our costs down, those costs also are – there’s some level of cost that’s passed along to the system installers as well, and they gain additional benefits through increased efficiency as well.

Operator

Your next question comes from Colin Rusch - Broadpoint AmTech.

Colin Rusch - Broadpoint AmTech

Can you talk a little bit about pricing in the U.S. for the utility scale projects if you’re benchmarking against wholesale prices, relationship to the time of use, market price reference? And then also talk about the timeline for building out projects and how you see that impacting your balance to system costs.

Michael J. Ahearn

Yes, so the only external price benchmark in the U.S. utility industry that we’re aware of is the market price [referent] in California, which was revised recently in terms of the formula. And on a time of day adjusted basis, it probably gets you into a range of $0.13 to $0.15 a kilowatt hour. So you have to back into an installed system cost from there, based on some assumptions about the cost of project financing.

And so that gets to be fairly complicated and site specific. I mean, you’re also looking at the radiance levels and the energy yield. But I think our working assumption continues to be that we need – you need to be pricing in that range of the MPR, maybe slightly above to be competitive with other renewable projects that are being bid into the RFP’s or are being discussed on these bilateral discussions.

That’s where we’ve been in our discussions in 2008 and where we continue to be in 2009. The timing – it’s possible to get some smaller projects done, relatively quickly, if you’re working with sites that have already been permitted or can be quickly. We showed that with El Dorado for example, but in terms of the larger pipelines of hundreds of megawatts or gigawatt level in California that’s a multi-year process to work through all the approval tiers and in some cases is transmission dependent. So we’re assuming 2010, second half of 2010 and ’11 for large volume throughput as sort of the earliest practical time and then decent, smaller projects in scattered areas prior to that.

Operator

Ladies and gentlemen this concludes our question-and-answer session for today. This concludes our conference call and thank you for participating.

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Source: First Solar, Inc. F4Q08 (Qtr End 12/27/2008) Earnings Call Transcript
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