First Solar (NASDAQ:FSLR) had a major rally after its last investor day in April. Though the company provided a positive outlook for the year 2013, the more important announcement was its entry into the crystalline silicon business with the acquisition of Tetrasun. First Solar has been boasting about the high cash flow expected from its existing project pipeline for several reporting periods, but the market has been skeptical mainly because of negative sentiments surrounding the solar market and concerns over warranty issues. With the recent announcement about the purchase of Tetrasun, however, it appears that the market has reversed its assessment.
To look into the valuation of First Solar, I have divided its business into four components:
- Existing project pipeline
- Module business
- Future project business
- Future entry into residential/commercial rooftop business
1) Existing project pipeline:
The ASP for First Solar's existing project pipeline is approximately $3.0/W (estimated from FSLR annual report and latest quarterly reports).
The total expected cost for these projects is approximately $2.0/W. This includes a balance of system (BoS) cost of $1.3/W and a module cost at production of $0.7/W. The BoS cost includes the cost of project acquisition, which is in the range of $0.3-0.4/W. These acquisition costs have already been paid for and are on the balance sheet as deferred costs for project assets.
Using these numbers, the gross profit per watt in First Solar's pipeline is $1.0.
The company's remaining pipeline is estimated at 2.5GW, which implies a total expected gross profit from the existing project business of $2.5B.
Total cash generated: $3.50B (with $0.4/W for project cost converted into cash).
2) Module business:
As a result of continuous heavy pressure on module pricing, there is little chance for First Solar to make any profit on module sales in next 2 to 3 years. After that period, if First Solar manages to reduce cost to $0.50/W or below, it can potentially again make profit from its module business. To simplify this valuation exercise, First Solar's module business has been considered valueless at present.
3) Future project business:
First Solar will continue to function as a project company. Assuming it can sell 1GW of large scale projects each year going forward at a price of $1.5/W and a gross margin of 20%, First Solar will generate an annual gross margin of $300M.
4) Future entry into residential/commercial rooftop business:
With its new c-Si technology, First Solar will also be able to sell into rooftop segment. Assuming it will function as a project developer in that market (like Solarcity, SunRun and others), a reasonable expected selling price is $2.5-3.0/W for that market segment (average price for Solarcity currently is around $3.5/W). Assuming, again, a gross margin of 20% and estimating a volume of 500MW, First Solar will make $250-300M per year.
Using the totals from business components 3 and 4, in the long run, First Solar can be expected to generate a total gross margin of $550-600M per year from its project businesses after 2015.
To calculate the net profit, overhead expenses must be subtracted from the gross margins generated by the above business segments. First Solar has annual operating expenses (OPEX) of approximately $400M. Since it will be entering into the rooftop project development business, its overall OPEX are unlikely to go down, even though OPEX for existing businesses are expected to go down. This analysis assumes that the reduction in OPEX associated with current businesses will be offset by the OPEX increase as a result of the entry into new businesses and therefore overall OPEX will remain the same.
Accordingly, for next 3 years cash generation will be driven by the existing project pipeline and will be around: $3.50B (part 1) - $1.2B (OPEX) = $2.30B.
Beyond 2015, the company, working as project business, will be generating around $200M/year (gross margin (600) - OPEX(400)).
First Solar will also need to invest in building a facility for new module lines, which will cost $300-500M, which needs to be taken into account. The company, it should also be noted, has net cash of around $500M (cash-debt) on its balance sheet.
Discounting all these cash flows at 10% the total valuation is approximately 3.3B. Many assumptions have been made to come to this valuation and there are several factors could contribute to over- or under-valuation.
Upside potential as compared to this valuation:
- Higher than expected gross margin in future project business
- The company is able to sell projects of more than 1.5GW combined per year in both market segments
- New high efficiency module business
Downside potential as compared to this valuation:
- Future business not profitable enough to generate even 20% gross margin.
- New warranty issues as First Solar technology is still not as mature as crystalline and there is significant risk in long-term durability of modules; this issue was highlighted with the warranty issues that occurred with First Solar modules in 2009 related to a specific production batch. Any future warranty issues are a significant threat to First Solar's financial condition as well as future project business.
- It still has to ramp up new crystalline silicon technology.
In conclusion, at First Solar's current market valuation of around $4B, all the upside potential seems to be already priced in and this stock should be avoided at the moment, in spite of all the hype associated with the solar stocks.