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SunPower (NASDAQ:SPWR) designs, develops, manufactures and markets solar electric power products based on proprietary processes and technologies. Solar cells are semiconductor devices that directly convert sunlight into electricity. SPWR’s cells have 3.1 watts and a conversion efficiency of approx 21%.

SunPower did a secondary of 7m shares at $29.50 in June 2006. Cypress Semiconductor (NASDAQ:CY) owns 76% of the common stock and 98% of voting stock.

SunPower's advantage is that they believe they can reduce the cost of cells by 50% in next five years and reach a grid parity. To accomplish this, they will rely on their expertise in semi manufacturing. SWPR is working on developing thinner wafers (using less silicon) with a better yield.

Grid parity in an installed system costs $4 to $4.50 per watt. Installation cost in the residential market is 50%, and in the commercial market, it is 33%. The cost of a module to reach grid parity is $2 to $2.25 per watt.

SPWR last quarter was producing modules at $3.45 per watt. This has not changed over past 9 months in spite of manufacturing improvements due to raw poly costs (module prices have gone up.)

Short Thesis:

1. High exposure to the high growth German market means a likely EPS miss
. SPWR’s main customers are Germany's Conergy AG (22% sales in six months ending June 2006 and 45% revenues for the year ending Dec 2005) and Solon AG (28% of revenues for six months ending June 2006 and 16% of sales for the year ending Dec 2005). SPWR has a fixed price agreement with Solon which means that an increase in the costs of raw materials hurts SPWR.

2. The German market has grown in past 4 years at a CAGR of 40%. Germany is the largest solar market by a factor of 2x over Japan (which has no subsidies). US market was 20% sales for SPWR.

3. Growth in the German market is a function of a subsidy which has a declining effect as each year passes. Renewable energy laws in Germany require electricity transmission grid operators to connect various renewable energy sources to their electricity transmission grids and to purchase all electricity generated by such sources at guaranteed feed-in tariffs. Additional regulatory support measures include investment cost subsidies, low-interest loans and tax relief to users of renewable energy. These programs have encouraged the development of Germany’s solar market, which has grown from annual installations of 79 MW in 2001 to 837 MW in 2005. Subsidy programs in Germany are designed to decline over time. The combined German subsidy from consumers and government totals some EUR 5 billion per year and accounts for 6% of its electricity.

4. Raw material costs of the polysilicon have not abated. Supplies are so tight that there is no spot market WFR is a major beneficiary. It will take at least two years before new capacity is available online. Suppliers of the raw poly have been “forcing” customers such as SPWR into long-term “take or pay” contracts. This means that even if prices in the marketplace are lower, SPWR is locked into high prices on at least 60% of its raw materials.

Evidence:

5. Anton Milner CEO of SPWR competitor Qcells has been making increasingly cautious comments in the past two weeks. The first remark was at the major PV show in Germany where he commented on the precarious nature of government-backed subsidies. He would like to see the PV industry get on a firm, open-market footing as soon as possible.

6. During a onference call from the PV show, Milner again expressed concerns about subsidies. He added that contrary to current thinking all the growth is in the Spanish and Italian markets (which are very small) and that the German market had slowed down.

7. In its Q2 Conf call, SPWR said the “market in Germany is probably looking flat for this year” (Page10).

8. Dirk Morbitzer, part of SAG Solarstrom, the largest turnkey builder of solar plants as financial products stated: “the current pricing doesn’t work in the German market. There is now no financial ROI.” He also confirmed that growth was in the 3rd tier markets and would not be able to soak up the drop in demand. He added that, as interest rates climb, these projects will be less attractive.

Risks:

1. The wide scale adoption of subsidies (i.e. Greece in 2006) allow financial projects to be built.
2. Rampant growth in Spain & Portugal offsets the slow down in Germany.
3. The easing of poly prices allows cost of modules to decline and spur demand.

SWPR's Financials:

Price: $27.50

Year End: Dec

Shares O/S: 69m

Market Cap: 1.8bn

Net Cash: 297m

EPS 2005A: -$0.35

EPS 2006E: $0.36

EPS 2007E: $0.64

P/E 2006: 76x

P/E 2007: 42x

Full Disclosure: I hold a short position in SPWR.

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