In two previous articles published in December 2013, the competitive positioning of First Solar (NASDAQ:FSLR) in the utility scale solar market and reasons why it was likely undervalued were covered. Shortly after those articles were published heavyweight Goldman Sachs came out with a sell recommendation which caused the stock price on First Solar to plummet by nearly 10% on the same day. Goldman's analyst, Brian Lee, indicated his reasoning was that First Solar wasn't positioned in the fast growing rooftop marketplace and he saw their earnings deteriorating. Just over three months later and the world looks rosier for First Solar - at least for their stock price. Even with recent volatility First Solar is up about 30% from where the stock price closed the day of Goldman's downgrade. So the question is what changed since Goldman's sell recommendation?
There were a number of items covered by First Solar in their analyst day presentation. Some of the key ones that may have had an impact include:
- First Solar's cadmium telluride (CdTe) module efficiencies are increasing and expected to go up to 17% by 2017. However, the more important point is that their energy density - the amount of energy that is actually produced in real world situations - will exceed multicrystalline silicon by 2015 and even exceed monocrystalline silicon by 2016. Furthermore, this increase in efficiency drives costs down. SunPower (SWPR) estimated in their analyst day presentation that for every 10% increase in efficiency there is a 35% decrease in cost. First Solar is projecting their efficiencies will increase by about 30% by 2017. This dwarfs the increases projected by the other key solar companies. The key takeaway for investors is that First Solar is headed to be not only the cost leader but will also lead in energy density as a result of the projected increases in efficiencies. As of right now the competition does not appear to have any technology roadmaps to address this threat.
- They indicated that TetraSun is on track to meet the cost and efficiency targets they outlined last year. If this remains true First Solar will have one of the lowest cost high efficiency silicon modules on the market which will allow them to better compete in the rooftop market.
- First Solar has a plan to split its manufacturing capacity to both allow it to scale to higher production levels as well as allow it to provide localized production capacity for other markets. This will be important in places like India where there is pressure to have local content in order to be able to bid on some opportunities. It should also be noted that First Solar indicated there were pending announcements for India. So perhaps we will see this strategy play out in India first.
- Projected profits and margins were relatively strong with good cash generation over the next 3 years.
Perhaps what seems surprising about this list is that much of what First Solar announced appears to have been to some extent predictable.
- As outlined in "How First Solar will Compete in the Solar Market", the direction on efficiencies and ultimately how that would translate into better module performance was already available. As suggested in that article, it seemed likely that First Solar's efficiency roadmap would improve through 2017 based on the additional GE patents which were announced in 3Q 2013. In addition, even before the analyst day the record cell efficiency was increased to 20.4%. While the absolute efficiency values of what First Solar's roadmap would achieve weren't known, certainly investors shouldn't have been surprised that the roadmap had improvements which further increased the competitiveness of CdTe technology in the real world.
- Looking at the progress on TetraSun no additional new information was released. First Solar indicated they were on track for launching in the second half of the year. While initial volumes are relatively small it is important to note that TetraSun had been announced a year earlier as a means of addressing the rooftop market which Brian Lee indicated First Solar was weak in.
- The manufacturing strategy was perhaps one of the more interesting strategies outlined by First Solar. While the specifics of the strategy would have been difficult to anticipate from previous information, the fact that they were looking at ways of localizing manufacturing capacity wasn't surprising given countries like India look for local content when assessing bids.
- Earnings were one of the specific concerns outlined by Brian Lee in his downgrade of First Solar. However, the article "Why First Solar is Undervalued" did an analysis of the backlog which suggested the $7.8B of backlog - nearly 2 years worth of revenue - did not appear to indicate any large deterioration in margins going forward. If one looks at First Solar's GAAP earnings for 2013 they made about $1.10 of earnings per share (EPS) per billion of revenue. If one looks at the next 2 years which account for the majority of First Solar's $7.8B backlog and taking the midpoint of their EPS guidance, they will make about $1.00 of EPS for each billion of revenue. So as suggested in the analysis, First Solar's backlog appears to be relatively profitable with no significant deterioration.
So while there were many available data points before the Analyst Day indicating that First Solar was moving in the right direction it appears Goldman and the market in general may have underestimated their potential impact.
Looking Forward - Valuation of First Solar
To value First Solar one standard approach is to use the Capital Asset Pricing Model (CAPM). This approach values companies in a fashion similar to how a loan is priced. A view of the free cash created by the company is viewed like the stream of payments on a loan and arrives at the "value" of that stream of payments which represents the value of the firm. This sort of technique is used by many investors including Warren Buffett. Many others use Price/Earnings (PE) ratios or PE/Growth (PEG) ratios which are essentially distilled, simplified ways to value a firm. While PEs and PEGs are an easy way to value a firm, it obscures some of the underlying assumptions. The CAPM model makes some of the key assumptions like growth rate, cash flow, risk and expected return more apparent. This allows an investor to take a view of the value of a company based on a longer term view rather than the current quarter or year results. Those that aren't interested in the details and assumptions used here can skip the next section and go to the section titled "Assessing First Solar".
Key Assumptions in the Valuation
While the CAPM model itself is fairly straight forward, the decision on what specific factors, such as cash flows and growth rates for a firm, must be based on forecasts. Discount factors and risk premiums are also debated. At one extreme Warren Buffett has indicated he discounts based on the long term treasury rate, while the classic CAPM model suggests using the current "risk free rate" (usually a short term government bond) with a risk premium for the stock. The risk premium is usually based on a calculation of the historical risk premium in the market (historically around 4%) plus a uplift for the "beta" of the stock, which is essentially an additional risk premium based on the volatility of the stock versus the overall market.
Since the exact growth and risk for a stock is never really known in advance, the valuation provided here provides a range of the possible valuations based on CAPM model. The model here assumes that First Solar's cash flow closely mirrors it's EPS. This is a key assumption and is based on First Solar's current 3 year outlook which projects approximately $10 to $13/shr in EPS and about $10 to $12/shr in free cash inflows - so cash flows roughly equal EPS. First Solar is able to do this as a result of the efficiency increases of their modules which allow them to produce more watts on the same manufacturing line without significant additional capital expenses above their depreciation rate. They have also indicated that they have equipment currently mothballed that can be brought online as volume increases. As a result, the base assumption is that net cash flows will mirror EPS. Growth assumes that EPS will roughly mirror growth in revenue on average. For those looking to reproduce the results the other assumptions in the model are:
- The various growth rates are applied from 2014 to 2020 which is the current time horizon for most industry forecasts.
- The growth is then divided by 2 from 2021 to 2023
- The residual value beyond 2024 based on a 1.6% growth rate (i.e. approximate half the historical GPD growth rate of 3.2% to be conservative on the growth beyond 10 years).
- First Solar's current cash balance of $15/shr is added to Net Present Value (NPV) of the cash flows.
The results are provided in Table 1.
Below are some considerations on how to assess risk and growth for the model:
Discount Rate - As noted, the discount rate can vary based on how investors view the risk. One extreme would be to base it on the average market return during the last 10 years of about 7%. Or a more the more standard approach of the CAPM model would be to sum up the current risk free rate (approximately 2.7% using the 10 year treasury bill rate), the historical market premium (approximately 4.2%) and apply the current beta (approximately 1.8). This would lead to a discount rate just slightly over 10%. As can be seen from the model the discount rate has a significant impact on the model. So it is important for investors to consider the appropriate rate to use. A good discussion on discount rates is provided at this link.
Growth Rate - A Google search for various views of growth for the solar industry comes back with most estimates for the period from 2014 to 2020 coming in between 15% to 20% per year with some forecasts north of 20% with few less than 15%. This variable also has a significant impact on the valuation so readers are encouraged to look at the market trend data and come to their own conclusions.
Assessing First Solar
In Table 1, given the outlined assumptions, the risk and the growth rates suggest the most likely valuations for First Solar will fall in the highlighted area with the discount rate likely between 7% and 10% and a growth rate between 10% and 25%. Arguably, given First Solar's current efficiency roadmap for CdTe, its expected entry into the rooftop market with TetraSun and its entry into new markets such as Commercial & Industrial and Hybrid applications they can potentially grow their market share and be in the higher ranges of the growth - closer to 20% growth.
As for the risk premium, management has a track record through the recent downturn of executing to their plans. In addition, First Solar is diversifying into silicon technology which provides it options in the rooftop market. It also has the largest pipeline of deals of any of its competitors. Its current cash balance provides significant advantage over its competitors in dealing with competitive threats. Arguably, First Solar is less risky than the other players and in the future will have less volatility and a lower beta. This would lead to risk premium that would be lower than 10% moving forward, perhaps more toward a mid point between 7% and 10%. Overall, this would put valuations between $89/shr and $128/shr, which is between 15% to 20% growth and a discount rate between 8.5% and 10%.
Other Factors to Consider
The above analysis argues that valuations should be in the $89/shr to $128/shr range. Goldman's current sell recommendation implicitly indicates they don't have as much confidence in First Solar's ability to grow their business at the market rates or view them as more risky than other companies in the market - or perhaps both. Given Goldman's resources and expertise in analyzing investments it's important not to discount their sell recommendation. However, it should be noted, not all Goldman's calls on First Solar have been correct. For instance, in January of 2011 Goldman put First Solar on their "conviction buy" list. They then reaffirmed on February 25th 2011 with a price target of $190/shr. However, the stock never closed again above the opening price that day of $161/shr. Over the next year the stock lost over 75% of its value ultimately reaching a low of just over $11/shr in June of 2012.
Bottom line, investors need to approach all recommendations with some skepticism, reviewing whether the rationale provided makes sense and takes into account known information and the potential dynamics of the industry. As successful investors like Warren Buffett have proven it's important to have a long term view. Analysts are paid for opinions and having an opinion which never changes does not drive paychecks.
The Argument for a Higher Valuation
Perhaps if anything changed as a result of the investor day conference it was investors began to better understand and believe in the longer term prospects for First Solar. And perhaps that is the most compelling buy recommendation. First Solar continues to move forward toward its long term goals and the solar sector growth prospects continue to improve as costs come down. First Solar continues to be one of the best positioned solar companies with CdTe technology that will potentially leave it with the lowest cost, highest energy density panels in the industry. At the same time it has diversified its technology portfolio with TetraSun. Its balance sheet and cash position is second to none in the industry which will give it significant flexibility in adjusting its strategy as the industry evolves.
In many ways First Solar's current prospects are more aligned to its prospects in 2007 when its stock began to rise on the promise of its low cost modules. The analysis here argues that First Solar is undervalued and would be more appropriately valued between $89/shr and $128/shr. Furthermore, given its balance sheet, diversified technology and business portfolio, arguably First Solar should be priced at a premium to its competitors. Whether First Solar receives a premium or if it will even get to the valuations suggested here in the near future remains to be seen. However, for long term investors, if First Solar can continue to execute on the plan it has outlined, time will take care of its valuation and today's prices will seem relatively cheap.
Disclosure: I am long FSLR. 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.