In this article I would like to go through the economics of a solar plant. In the past 12 months or so, more and more solar companies have entered the downstream part of the market. After a horrible period for the industry in 2011-12 and massive oversupply in the market, solar companies realized that the only ones making money were the downstream developers. Cutthroat solar module prices meant many companies were operating with a negative gross margin for a few quarters. The only ones that benefited from this were the solar power plant developers, which enjoyed a very low cost for modules, on the one hand, and a juicy feed-in tariff (FiT), on the other.
This new segment, which every major solar company operates in, will change the face of the industry. It will generate a high-margin recurring revenue stream, which will provide companies some financial "oxygen" to mitigate their awful balance sheets. As the companies build a larger installed base of solar projects, they will be less sensitive to the occasional "hick-ups" in demand in one quarter or another. So let's jump in.
How to Build a Solar Power Plant
What does a solar power plant look like?
This is a 200 MW power plant built by JinkoSolar (JKS) in Jin Chang, China. Remember this plant, as we'll get back to it in a jiffy.
A solar power plant has several components:
- Solar modules - the heart of the power plant. The solar modules convert sunlight to DC electrical current.
- Inverters - The solar panels' output is DC. The electricity used in the grid is AC. To feed the grid with AC, the power plant needs to convert the DC it gets from the panels to AC.
- Various wiring - junction boxes, DC cables, transformers, etc.
- Other electrical components - monitoring systems, switches, etc.
Building a solar power plant requires some engineering work, a leveling of the ground, and of course the labor involved in putting everything in place. A basic schematic diagram of a PV power plant looks like this:
Source: IIT Bombay
After the power plant is in place, the sunlight hits the PV array, which generates DC (direct current) and delivers it (after a few steps) to the inverter. The inverter converts the DC to AC (alternating current) and delivers it to the grid. The grid is agnostic to the source of the AC it gets. From the grid we get AC electrical current through the outlets in our homes.
The Business of Downstream Solar
The business of downstream solar is about building solar power plants, connecting them to the grid, and generating revenues from the electricity the plant sells to the grid. To help solar developers finance their projects, a country (China, the U.S, etc.) usually offers a 20- to 25-year FiT contract. This means the owner of a solar power plant locks in his selling price for 20 to 25 years, about the life span of solar modules. This turns the solar power plant into a financial asset that yields a very high-visibility stream of revenues for 20 to 25 years, which helps developers gain financing more easily. Every time the FiT rate is higher than the country's wholesale electricity rate (the rate at which it buys electricity from conventional power plants), it is actually a de-facto subsidy.
When the solar companies started examining this business, they used their own built-in moat against sole-project developers. We can assume that the cost to build a power plant, excluding the cost of the modules, is pretty much the same for anyone, a module manufacturer or a pure developer. What isn't the same are the module costs. The pure developer has to purchase his modules from one of the many solar companies, mainly in China. The module manufacturer can enjoy a much lower cost by using his own modules for a project and will thus enjoy a much profitable business compared with the pure developer.
Whenever a solar power plant is connected to the grid, the owner has to choose one of two possible actions. First, he can sell the power plant to a third party and enjoy the quick bang he gets for his buck. The other option is to keep the solar power plant, operate it, and enjoy the lucrative cash flow for the next 20 to 25 years. An excellent analysis of the benefits of keeping versus selling a solar power plant was made by Robert Dydo, and I urge anyone who wants to deepen his understanding of this business to read it.
Instead of estimating costs, we can go to real-world data. JinkoSolar reported that its 200 MW power plant in China carries an investment of 1.8 billion RMB, or $297 million. This translates into $1.48/watt. JinkoSolar has a module cost of just under $0.50/watt. That leaves us with a cost of about $1/watt for all the other expenses to build a solar plant, excluding module costs. A pure developer is likely to see a total cost per watt north of $1.80, or 20% higher.
Yingli Green Energy (YGE) estimated that it will see a cost of $1.29/watt to build a solar power plant. With this estimate, we can assume that a solar company can build a solar power plant at a cost of $1.30 to $1.50/watt, at current module costs (which are still on a downtrend).
Operating and Maintenance
O&M expenses are a whole lot smaller for a solar power plant compared with a conventional (gas/coal/oil) power plant for one simple reason: Solar plants don't consume any fuel other than sunlight, which of course is free.
The following table sums up the elements of a solar power plant's O&M:
What does all of this cost the owner per year? A general rule of thumb in the industry says 1% to 4% of the total project cost.
Source: Utility-Scale Solar 2012, published September 2013, U.S. Department of Energy. The dashed lines are actual data.
We can see that the Topaz and Solar Star PV power plants' O&M expenses are in the $20 to $30/kW range. Given that both of these plants are located in the U.S., I suspect that O&M expenses in China are even lower. For conservative reasons, I'll use the $20/kW figure. Taking JinkoSolar's $1.48/watt capital cost, the $20/kW, or $0.02/watt, makes the annual O&M expenses 1.3% of the initial capital costs. In the JinkoSolar example, it takes up to $3.8 million a year to operate and maintain its 200 MW facility.
What revenue amount can a solar power plant generate in any given year? The answer is basically a function of two factors. The first is the price the plant gets for each kWh it delivers to the grid. The second factor is how much KWh it can generate from the existing capacity (i.e., how many KWh a 200 MW facility generates a year).
Again, let's go back to the JinkoSolar 200 MW facility. JinkoSolar estimates that the plant will generate 300 million KWh when it's completed. Let's break down its statement to see how many sunlight hours JinkoSolar took into account when it calculated the 300 million kWh figure.
- 200 MW equals 200,000 kW.
- 300 million kWh divided by 200,000 kW is 1,500. This means that each installed kW will generate 1,500 kWh each year.
- 1,500 kWh divided by 365 days equals 4.1. This means each installed kW will get 4.1 hours of direct sunlight each day, on average.
This result, 4.1 hours per day, sounds like a very reasonable assumption. What price does JinkoSolar get for the kWh it will generate in the 200 MW facility? According to China's new FiT plan, the facility looks to be eligible for the 1 RMB per kWh rate. (The plant is located in Zone 3, on the outskirts of Beijing.)
Source: Google Maps. 'A' marks JinkoSolar Jin Chang facility.
So 300 million kWh a year carries a price of 1 RMB/kWh, or $0.164/kWh. That comes to $49.2 million in recurring revenues each year.
JinkoSolar reported in 2013's third quarter that its power sales business enjoyed a 60% gross margin and a 30% net income margin. One has to remember that these kinds of solar power plants are built with a financing rate north of 70%, so interest rates are a big chunk of the equation. Let's say that JinkoSolar has the same access to capital as all the other big solar names: Yingli Green Energy, Trina Solar (TSL), and others. That means that most companies will show the same 60% gross margin and 30% net margin.
The Huge Impact on Future Results
Let's focus on the top three downstream players in China: JinkoSolar, Trina Solar, and Yingli Green Energy. What kind of impact will this business have on the companies' financials in the next few years? Let's take a look at the companies' plans for 2014-15.
- JinkoSolar has already connected more than 200 MW from projects to the grid in China. The company plans to connect another 300 MW in 2014. Assuming the company will increase its build rate in 2015, JinkoSolar can reach about 900 MW connected to the grid projects by the end of 2015.
- Trina Solar plans to achieve a quarterly build rate of 100 MW to 200 MW in 2014. At the midpoint, Trina will reach 600 MW in 2014. We can assume it will further increase its build rate in 2015 and reach about 1.6GW of projects by the end of 2015.
- Yingli Green Energy aimed for 120 MW to 130 MW in 2013. In 2014, the company says, it plans to build projects generating 400 MW to 500 MW. We can assume that in 2015 Yingli will build approximately 700 MW to 800 MW, thus reaching about 1.3GW of projects by the end of 2015.
Summing up the data above, if no project is sold, by the end of 2015 JinkoSolar will have 900 MW connected through its grid projects, Trina will have 1.6 GW from its connected projects, and Yingli will have approximately 1.3 GW.
We don't know exactly how many of these solar power plants will be sold and how many will be operated. But let's examine the downstream business of each company and its run rate as of the end of 2014, under the assumption no plant is sold.
|Company||JinkoSolar||Trina Solar||Yingli Green Energy|
|MW connected to the grid||900MW||1600MW||1300MW|
|Annual KWh generation||1.35B||2.4B||1.95B|
Revenues are calculated using a price of 0.95 RMB per kWh. Net income is calculated as 30% of revenues, according to JinkoSolar's recent results.
This will have a paramount effect on all the companies. This business will provide a visible and recurring revenue stream, which will help the companies smooth out any "hick-ups" in module demand. This business is highly profitable, which could make the days of red ink in P&Ls a thing of the past.
The Case for Spinning Off the Downstream Business
Two weeks ago, JinkoSolar announced that its board is considering different alternatives for separating its downstream business. This makes sense, as the downstream business is very different from the module manufacturing business. Moreover, some of those projects are financed with debt, which can make up more than 70% of the project's cost. The balance sheets of these companies look pretty ugly with very high levels of debt. Separating the downstream business and creating a new entity that will bear that debt might be in the company's interest. A different entity can raise funds through an IPO or secondary offerings in the future without directly diluting shareholders. It's too soon to evaluate these options, but I believe any result will be positive for existing shareholders.
Let's try to value the downstream business as a stand-alone business so we can figure out what that piece of the business will be worth 24 months from now. Using the figures in the table above and assuming this business should be valued at the same P/E that other power companies are valued at, I made a list of eight electricity utilities and their respective PE ratios.
NEE PE Ratio (TTM) data by YCharts
We can see that the companies above are valued at a PE of 15 to 25. Because the solar downstream business will see much higher growth rate than conventional electricity utilities, I think a PE of 25 to 30 gives the solar downstream business a very reasonable valuation.
|Yingli Green Energy||$2.8B||$3.3B|
Numbers refers to each company's downstream business market cap as a stand-alone business.
When comparing these numbers to the current market caps of the companies (JinkoSolar = $783M, Trina Solar = $1.2B, Yingli = $950M), we can see that the downstream segment could triple the companies' current market caps. I think the market greatly overlooks this development, thus offering us investors a bargain. Buy the stock and get the downstream business for free. You don't get a lot of deals like that in the stock market.
In this article I examined the business of solar power plants. Any way you look at it, this business is very profitable and is expected to continue seeing high growth in the next years and decades. Wall St. takes time to notice changes, especially big ones. An individual investor can notice these changes long before Wall St. I believe there is a huge opportunity for any investor willing to look two steps ahead, and the recent drops in share prices offer a unique entry point. I'm looking forward to your feedback.