First Solar (FSLR) is on the calendar to report fourth quarter 2013 financial results the last week in February. Understandably, most investors will be focused on sales and earnings. However, First Solar management has made significant changes in the company's production profile by selling key assets. It is would be a good idea to pay attention to First Solar's balance sheet.
Have management's decisions improved First Solar's capacity to generate returns for shareholders? What does that mean for stock value?
Most investors would turn first to the classic Return on Assets (ROA) measure to answer this question. It is easy to for all us to calculate - divide Net Operating Profit after Taxes (NOPAT) by Total Assets. Total Assets are easily read from the balance sheet and NOPAT [Operating Income X (1 - Tax Rate)] requires only Operating Income and the company's Effective Tax Rate from the income statement. In the most recent twelve months, First Solar has earned a return on assets of 5.9%.
The measurement of one period does not mean much by itself. Comparison of the most recent year has more meaning when stacked up against previous years. Historic Return on Assets for First Solar suggests a sketchy track record and leaves no clear trend. Yet when we consider the average return on assets of 3.5% for the solar industry it looks like when things are going well, First Solar gets more out of its assets than its peers.
Return on Assets
Yet when year-end 2013 financial results are made available to us in the last week in February, we probably should do a bit more than update our Return on Assets calculation. The problem with ROA is that it treats all assets alike.
When the press release comes out, like every other public company, First Solar will display a balance sheet in the usual accounting format with liquid assets at the top and fixed assets near the bottom. Accountants also like to categorize assets according to whether they are tangible or intangible, financial, etc. Investors need to think about the assets in terms of which ones are central to operations and producing cash flow.
Is First Solar generating enough return to justify the cost of financing its assets?
This is where we reach for another classic measure, Return on Invested Capital (ROIC). Again we use After Tax Operating Income (NOPAT) as our return, but we are allowed to rummage around in the assets to pick and choose those that are central to producing cash flows: Operating Fixed Assets and Non-cash Working Capital. We can exclude cash and financial assets. We can also exclude assets not being used in operations, such as assets held for sale or minority holdings in other companies.
Return on Invested Capital
Of course, will still have the two difficult years in 2011 and 2012, but First Solar's returns seems so much more impressive when we weigh earnings against those assets being actively used to generate them. Fixed Operating Assets and Non-cash Working Capital are estimated to total $3.2 billion compared to total assets reported on the balance sheet $6.6 billion according to GAAP. Eliminated are all the financial assets and accounting treatments for taxes. Also eliminated is the Mesa facility management put on the auction block, which is now shown as "assets held for sale" on First Solar's balance sheet.
Yet with the ROIC measure in our toolkit, we can do more than just a time series comparison. It is handy to compare ROIC to a firm's Cost of Capital to test whether the company is investing in good enough projects. I estimate First Solar's cost of capital is approximately 9.0%. (See the note at the end of this article for the steps to get this number.)
Now we are getting somewhere. First Solar is earning about 11.9% on its operating assets but its cost of capital to pay for asset investments is only about 9.0%. This means First Solar generated excess returns above what it costs to raise its investment capital.
We all know that investors only need to know what is a company is going to do for them next. Last year is, well, over! That is why the upcoming financial report and the usual commentary on coming quarters is important to confirm our hunch that First Solar has more excess returns in its future.
The consensus estimate is $3.76 billion in total sales. Even if the company only delivers operating profits similar to the average over the past year, it could mean as much as $400.0 million in after tax operating profits. If the balance sheet remains largely unchanged from the situation at the end of September 2013, then operating assets will be approximately $2.9 billion. Stacked end-on-end these assumptions and estimates point to a Return on Invested Capital near 13.75% in the coming year - still well above the cost of capital.
If investors are given this validation, then investors can expect First Solar's value to increase as returns on investments exceed their costs. In my view, that makes the stock is interesting even at the current price just 15% below the 52-week high. Admittedly, that view goes against the pack, which appears to favor an unweight rating on FSLR. However, management has made a decision on assets that has ramifications for long-term growth and asset returns and that decision appears to bode well for returns.
Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.
Note on Total and Operating Assets: While some use beginning of the year assets in return on assets or invested capital, in this exercise average assets were used to calculate return on assets and invested capital.
Note on Cost of Capital: Since the company tells us the fair value of their debt is close to book value, we can estimate the cost of debt is near the prevailing interest burden of 5.25%. The Capital Asset Pricing Model yields a cost of equity near 10.0% is we assume a risk free rate near historic averages of 4.0% and an equity market risk premium of 3.1%, also a historic average. FLSR beta or risk measure is 2.00. A bit more math provides us first with the mix of debt and equity in First Solar's total capital picture. Then we can weight the cost of debt and cost of equity estimates according to how much the company relies on each, getting a weighted average cost of capital near 9.0%.