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A-Power Energy Generation Systems (OTC:APWR) is a provider of distributed power generation systems (DG) in China and is in the process of launching a wind power business. Its stock price has more than tripled this year as investors considered the company a proxy for the fast-growing alternative energy sector in China, especially the wind power market.

Additionally, most of the major Chinese wind power players are listed either in mainland China or Hong Kong. APWR enjoyed an extra tailwind due to its perceived scarcity value.

However, a reality check of the wind power market in China suggested that APWR might be facing significant headwinds as it tries to jump-start its wind turbine business. Its current stock price has simply priced in too much of a blue sky scenario and significantly underestimates a wind chill factor of the execution risk in the current market environment.

Reality Check

Supply deficit of wind turbine market in China has given way to manufacturing overcapacity in 2009. Since 2005, the wind power installed capacity in China has experienced a triple digit growth rate. However, this explosive growth has quickly been surpassed by the manufacturing capacity as more and more companies jumped on the wind power bandwagon. Going forward, the demand growth is expected to gradually slow down.

According to the Global Wind 2008 Report prepared by the Global Wind Energy Council, “demand in the decade between 2011-2020 is forecasted to be 80 GW, or about 8 GW per year”. This will be more than met by the existing manufacturing capacity in China – according to Chinese Wind Energy Association, the top four Chinese turbine manufacturers (Sinovel, Goldwind, Dongfang and Shanghai Electric) already have a combined capacity of 12GW now. APWR stated that it has the largest wind turbine production facility in China with 1125 MW capacity (according to its press release on January 11, 2009), however, in an industry with growing overcapacity, the utilization rate matters more than size.

Wind turbine market in China is highly concentrated with limited incremental market share for new entrants. There are currently 70 wind turbine manufacturers in China, but the top 10 accounted for a staggering 90% market share by the end of 2008. There is little market share left for new entrants such as APWR unless the demand grows significantly more than expected or the new entrants focus on the international market. APWR may be able to mitigate some of this risk by selling 2.7 MW turbines as most of its competitors are selling 0.75MW, 1.5 MW and 2.0MW models.

However, Sinovel, the largest wind turbine in China, has just started to manufacture 3.0MW (for offshore wind farm) in 2009 and other top manufacturers are also eyeing the high capacity turbine market. Direct exports may not be a solution for APWR as its technologies are all licensed from European companies which may have rigid geographic limits on the licensed products.


Wind turbine manufacturing is not the sweet spot in the wind power value chain. A typical wind power value chain in China includes wind farm operators (usually the government owned utilities), wind turbine manufacturers, wind turbine components providers, and raw material providers. Wind turbine manufacturers have the least bargaining power along the chain and are potentially squeezed from both upstream and downstream participants.

The overcapacity has led to increased competition and price wars among turbine manufacturers, which has eroded their bargaining power against wind farm operators and weighed on the top line.

On the other hand, there is a significant supply deficit for key turbine components as the explosive growth of manufacturing capacity has not been matched by the similar growth of qualified component providers in China.

Consequently the pricing and delivery terms are more dictated by the component suppliers, which will eventually weigh on the cost structure of turbine manufacturers. APWR will have to face similar challenges, though its joint venture with GE will mitigate these pressures with respect to one component: gearboxes.

Wind power business is very capital intensive. To build a wind power turbine business from scratch, it takes significant upfront capital outlays to acquire land, equipment, technology licenses and other necessary manufacturing facilities. For example, Beijing-based wind turbine new entrant Shengguo Tongyuan recently invested RMB 460 million ($65million) in the first phase of a wind turbine project with annual output of 1,000 units of 1.5MW wind turbines.

The second phase will cost an additional $90 million. After the business is up and running, the ongoing working capital need is also high as there is a natural funding gap between current assets and current liabilities. For example, Goldwind Technology, the 2nd largest wind turbine manufacturer in China, has accounts receivable days of 96 and inventory days of 116 while the accounts payable days are 58.

For some small players with less bargaining leverage, the accounts payable days could be as low as 30. APWR’s existing DG business has relatively low working capital requirements: both receivables and inventory requirements are minimal - its A/R days are 20 and inventory days are only 7.

With the ramping up of its wind power business, its working capital needs will have to increase significantly to be more in line with the industry norm and its cash balance is likely to go down significantly.

Valuation

Buying APWR now is essentially buying its DG business and a call option on its new wind turbine business and its JV with GE. It will make a great investment if its DG business is traded at a discount and the call option is free. Current valuation does not present a good entry point, however.

  • Distributed generation business. DG is APWR’s bread and butter business, where it has a good track record. Though it has a high growth rate, the business has relatively low operating margins (~10.6%) and is quite sensitive to the macro economic cycle (evidenced by its downward revision of 4Q08 earnings). We find it hard to apply a higher than 10x P/E on the company (that is assuming no discount factor for an emerging market small cap stock). Management’s earnings guidance for 2009 is $32 million, implying a market cap of $320 million vs its $430 million market cap on 6/15/09.
  • Wind turbine business. We are hesitant to assign any value to its wind power business as at this point as it is still in a very early stage and it is hard to forecast “normalized earnings” for that division. The company stated before that it has signed a letter of intent for 380 units of 2.7 MW, but during the first quarter earnings call on 6/16/09, it said it will only deliver 2 units by the end of July and potentially another 30 units of 2.7 MW (300 manufacturing capacity) as well as 40 units of 750 kw (420 manufacturing capacity) by the end of 2009. As we point out in the reality check section, APWR has not picked the best timing in launching its wind power business. It needs to prove that it has a viable business model and the capital sources to compete and grow this business in the increasingly challenging market dynamics. 2010 is more likely a make-or-break year for APWR. Until then, there should be no tail wind for its valuation.
  • GE JV – the JV makes long term sense for APWR. As we mentioned in the reality check section, component providers are the sweet spot in the wind power value chain. Additionally GE will use the JV as a potential supplier for its business in Southeast Asia.

Near Term Catalysts

  • 6/16/09 earnings release: as expected, not a lot of new information to support its current valuation, especially in regard to the order book for its winder power business and how APWR would fend off its more established competitors. Current 2009 guidance does not include contribution from wind power business as the company is still working with its customers on pricing terms which for competitive reasons could not be disclosed.
  • 20F filing possibly by the end of June
  • July 2009: the deadline to deliver 2 units of 2.7 MW wind turbines

Disclaimer: the author has no exposure to APWR.

Source: A-Power Energy Generation Systems: Headwind or Tailwind?