Strategy For 2014 Solar Portfolio: Looking For Undervalued Situations

Includes: HQCL, JASO
by: Robert Dydo


JA Solar operational improvements gone unnoticed by the market.

Hanwha Solar's high margin rate is not reflected in the company's stock price.

Both companies offer undervalued situation for solar investors.

Having most of the fourth quarter results behind us, it is time to summarize what to expect from 2014 in the case of portfolio development, and which companies are likely to make it worthwhile for investors.

Let's start with a company that became the poster child for the inability to grasp the market value. JA Solar Holdings Co. (NASDAQ:JASO) seemed to have done two things wrong in the recent past, and has not been forgiven for it. One, it consolidated its shares, and two, it sold equity at prices many considered as giveaway.

Since 2011, a year of discovery of a significant module oversupply and price drop, consolidated shares of JA Solar are 66.7% (on March 20th, 2014) below its value on January 1, 2011. On the other hand, shares of Jinko Solar have appreciated 60%, and Canadian Solar's are 185% higher. One would assume that things are downright lousy at JA.

During the second quarter's lending crisis, many companies faced the necessity to sell equity. One could argue that JA sold hers cheaply, considering its relatively strong balance sheet. Issuing warrants complicated the interpretation and impacted results of the third quarter while helping Q4 outcome. It also opened up possibilities for hedging and finding risk reduction in short selling of the stock, which has contributed to its weakest stock performance.

JA Solar reached net income in Q4, when excluding derivatives, with a $9M operational profit. The company has gotten the GM, which was in line with other players. At least four recommendations were issued for the stock, including Axiom's famous bear Gordon Johnston, who had given JA a price target of $16 per share. The stock has done absolutely nothing, with the exception of a pair of spikes the day before and the day of the release.

In the matter of guidance, JA expected to ship 2.7-2.9GW of modules and cells, including 200MW as part of wholly owned projects. This compares with 2.1GW shipped during 2013, or expected growth of 38% at the high end of the guidance.

So, why is JA worthy of attention, given the lukewarm market response? For one, reliability of the market's valuation is not always qualified. I can see that gross margins are competitive. The overspent operating expenses, including write down of some $5M, will be gone in upcoming quarters. The financial portion of the income statement does not carry risks; reasonable interest rates and presence of derivatives can improve the company's performance.

In order to generate more profit from operations, three things need to happen for the company. First, average revenue per watt generation needs to grow; and second, the sheer sales of higher-priced products must also increase. Luckily, one is a consequence of the other.

The market neglected the fact that during Q4 ratio of module to cells was only 54%. The demand penetration was more than half dedicated to China, lowering ASP and also adding more solar cell sales. Modules have higher average selling prices (NYSE:ASP), and during Q3, percentage of modules to cells was 60% generating 3 cents higher per absolute watt than the fourth quarter. Conversely, processing cost is higher when making modules, but processing dropped from $0.51 in Q3 per absolute watt sold to an average of $0.45 in Q4. Comparing both statistics, costs dropped 100% faster in Q4 than revenue.

It has also fallen on deaf ears that JA will ship 70% of modules, or 2GW out of the 2.8GW total shipments. Keeping its gains in processing cost reduction, JA could move toward a gross margin closer to 20%, guiding a 100% module shipments' increase over 2013.

In order to facilitate this, as soon as Q2, the company is rapidly expanding its capacity to 2.8GW, both in cells and module. This fast expansion not only shows that high-end modules are in abundant demand, but selling more modules is recognized by the company as a real money maker.

The third thing that makes JA a convincing investment is its relatively low profile on international markets in 2013 and possible change in 2014. Using our research, despite having a significant presence in Japan, JA had only around 56% of its shipments during 2013 in international markets. In comparison, Trina Solar had 63%.

In the case of JA, the quality of module made the organization an ideal tolling partner to Japanese corporations. Tolling utilizes value chain, but lowers revenue generation per watt. JA spent a lot of effort to highlight branding strategy, which suggests tolling becoming a secondary objective.

Packaging everything together, the rapid expansion, 100% module sales growth and the brand name advances described by management, one can only imagine gradual improvement on revenue generation per watt.

While it is too early to say if this strategy works, during January, JA set a new record for its highest global delivery in one month. The company has also guided strong Q1. Its production lines are sold for months ahead, based on recent clippings from Chinese newspapers. All this while the market seems to be sleeping at the wheel, in a way it has done for the better part of three years.

I wrote an article about Hanwha SolarOne (HSOL) not expecting to see any analysts at the company's fourth quarter conference as an attempt to lighten up mostly dull matter of sorting numbers. I was laughing when this turned out to be a reality. When the announcement came that, excluding another mop up charge to end the year, the company reached close to Trina Solar margins, stock saw a 30% increase. Since then, the market's unqualified treatment has taken all of it back, mostly as a result of not having a single analyst from investment banking to discuss how to assess the company.

Hanwha did not make a profit in Q4, but due to the nature of the quarter and cleanups of the balance sheet, came close. The company unquestionably has two obstacles to making its net profit and improved value.

One is a scale. In order to promote the revenue generation, more modules need to be sold. The company guided expansion to 2GW from the current 1.5GW, but did not provide a timeline for completion. It also confirmed 30% tolling plan, getting closer to QCELLS in business, but not necessarily improving that much-needed revenue generation.

Second, Hanwha needs to improve its financial section of the balance sheet. The company is paying hefty, highest interest on one of the lowest amounts of debt among the peer group. Fixing the interest rate is a matter of rewriting loans, and getting the status of a tier-1- company. Korean analysts discovered that Hanwha must have gotten GM over 10% long before the market, when Beijing Bank granted $500M credit facility in December, learning this level of GM was one of the prerequisites. Meeting this requirement could subsequently lead Hanwha to get the privileged borrowing rate and follow with loan rewrites to emulate other companies' rates. This task, in my view, is easier than the improvement on gross margins.

In the area of guidance, Hanwha offered what normally is not offered by Chinese companies: gross margin of 15 to 20% for a full year. While the market got excited, volume guidance, a 25% increase in the module shipments, spoiled the mood quickly, knowing that the big dogs were heralding 50% increases. Then the company talked about 200MW planned as solar plant strategy. JA Solar made an effort to include the solar plant numbers in the yearly guidance, but I am not sure if Hanwha did. Adding 200MW on the top would suggest around a 58% increase, a substantial utilization of capacity and the second largest increase percentile in modules next to JA.

During January 2014,Hanwha like JA, has shown an increase in module shipment in international markets, a new company record. It was so strong that it became third largest delivery, beating Canadian Solar Inc.(NASDAQ:CSIQ). In 2013, the company dedicated most of its sales to global markets, having the highest ASPs among the group. Strong deliveries in January support high Q1 shipments, described as "similar" to Q4 figures, the largest shipment quarter for Hanwha. The volume growth produces speculation that Hanwha is already in capacity expansion mode. This, associated with high ASP driven, among other things, by module retailing in South Korea, puts improvement in revenue scale as a strong possibility.

Another major factor, solar plant ownership, has not been recognized in my analysis for either company. The reason is simple: there is little evidence of it today. Announcements made by JA did not show details about the nature of plant development, but during the fourth quarter conference call JA managed to rectify the situation. Dropping info regarding construction of a 2MW solar plant in Japan was indeed a real surprise but did not get a lot of attention, even from analysts present at the call.

In the case of Hanwha, the company released plenty of news describing engineering, procurement and construction engagement in China. While the company hinted at a shift in strategy, it failed to provide details during the conference call, perhaps because it was never asked such a question. We know that over 1GW of projects are in their portfolio. A recent one, a distribution generation project planned for rooftops of Wuxi City, includes the intention to keep 100MW for FiT revenue. We can assume plant ownership, and FiT revenue generation is an adding- value mechanism, only when one looks at benefits to JinkoSolar. Both JA and Hanwha have this as future premium, without recognition today.

In my view, both JA and Hanwha are typical undervalued situations that the market failed to upgrade on recent progress. They are candidates for the solar-ready portfolios during 2014, with price per share representing 2011 levels and having plenty of growth coming to them this year.

Disclosure: I am long JKS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.