A Solar Play on Reckless Real Estate Development in China

China based solar power play Suntech (STP) reported third quarter earnings results on Monday. For the quarter, the company had revenue of $163 million and EPS of 22 cents vs. analyst expectations of $170 million and 18 cents, respectively. While results were short of analyst expectations, the Street's initial reaction was favorable and the stock rose 3% in early trading. Shares closed the session lower, though, creating what I view as a compelling entry point.

Suntech is arguably the least liked/understood solar play out there. Companies such as SunPower (SPWR) and Evergreen (ESLR) grab the spotlight in the U.S. Even so, Suntech is the fastest growing polysilicon solar company trading in the U.S. and revenues are forecast to grow 2.5x between 2006 and 2008 with margin expansion likely. Bears knock Suntech for a number of different reasons.

First, the company is operating in China, where subsidies that make solar power installations affordable are sparse. Second, Suntech has been aggressive in its growth, choosing to sacrifice near-term gross margin gains in favor of procuring polysilicon, which represented 70% of its cost of goods sold, in the tight spot market. Third, the company acquired Japanese based MSK in August for $300 million, and the deal has not lived up to expectations with MSK leading to the revenue shortfall in the most recent quarter despite outperformance of the company's legacy solar cell and module business vs. expectations.

While all of these points are valid, there are a number of factors being ignored by investors. Sure, Suntech is seemingly at a disadvantage because it operates in China and not Germany like EverQ, a joint venture between Evergreen Solar, Q-Cells, and REC. But China is a rapidly growing economy and the country is targeting having 15% of its electricity generated from renewables by 2020.

Also, China's economy is booming and the Olympics in 2008 will likely spur additional investment in the country. Such rapid economic development will further strain China's environment and lead to an increased focus by government officials on using cleaner sources of energy. Lastly, its largest customer has historically been German based SolarWorld, so expansion into markets outside of China, such as Greece or France, is not out of the question.

The company has sacrificed near-term gross margin performance in favor of top line growth. Specifically, the company has sourced 70% of its polysilicon in the spot market in recent quarters. Polysilicon is in short supply due to a healthy semiconductor market and 40% plus annual growth in the solar market. Polysilicon spot prices have more than tripled in the 18-months as a result. This has weighed on gross margins, for sure, but similar to a legacy airline struggling to cope with high oil prices, STP has the most leverage to a decline in polysilicon spot prices.

In addition, the company has announced long-term contracts with MEMC (WFR) and others that cover anywhere from 70% to 100% of STP's potential cell production in 2007. I believe the company would not have entered into a long-term polysilicon contract at unfavorable prices given the potential for a looser polysilicon market in 12-24 months. Therefore, STP should be able to maintain its current gross margins and outgrow the industry or improve its gross margins with steady growth. Based on my analysis, the company could see a 10 cent EPS improvement from every $10 to $20 decline in polysilicon, an equation I am not sure many sell side analysts are considering at this point in their forecasts.

Turning to MSK, it is clear the acquisition has not lived up to expectations. In the quarter, MSK, a module maker focused on integration into buildings, had revenue of about $14 million vs. analyst expectations for about $25 million. Consolidated STP gross margin came in about 300 basis points short in the third quarter as a result of MSK's shortfall, and the company cited a shortfall in cells in order to support MSK's growth. This should dissipate a bit in 2007 with the company's long-term supply agreements supporting STP's growth plans.

Also, management noted that it will target the higher margin Building Integrated Photovaltaics [BIVP] market with MSK going forward, but investors should not lose sight of the fact that the total MSK deal will only cost the company $300 million, or about 7.5% of its total market capitalization, and the Street is heavily discounting future contributions from the business given the near-term shortfall. With BIVP opportunities potentially driving gross margin and capacity utilization improvements going forward, MSK could fuel revenue outperformance in 2007 and into 2008.

Fourth quarter guidance calls for revenue of $166 million to $170 million, which excludes the impact of MSK. Including the company's fourth quarter guidance for MSK of $60 million to $64 million in revenue, STP's implied fourth quarter guidance is $226 million to $234 million. The Street had been looking for fourth quarter revenue of $237 million, and once again upside in legacy STP will be offset by disappointing results from MSK.

I believe investors should look past MSK for now and focus on a) Broad opportunities to exploit reckless real-estate development growth in China b) The company's industry leading gross margin leverage to polysilicon price declines c) Long-term polysilicon contracts that take the company out of the spot-market and provide more confidence that management will be able to reach its production growth targets, and d) Valuation on a P/E basis that is a discount to the company's long-term growth rate potential and its peers.

See also:

• Suntech Power Holdings Q3 2006 Earnings Call Transcript
• Suntech Power Shining Bright