- Canadian Solar shares have sold off by almost 20% following the company's earnings announcement last Friday.
- Investors seem to have misunderstood the situation of the company's fundamentals, as the company's business prospects haven't worsened.
- The drop in the share price has presented a highly asymmetric risk/reward investment for long-term investors.
The shares of Canadian Solar (NASDAQ:CSIQ) sold off heavily in the last week as a result of investors reacting irrationally to two events taking place.
Misunderstanding #1: The Deutsche Report
The first event took place on Thursday, May 15, 2014, and was when Deutsche Bank released a research report that stated that Deutsche's analysts don't think that China will be able to reach its 14 GW solar installation goal (8 GW distributed, 6 GW utility)
However, when one digs a step deeper into the research report, if the scenario that Deutsche thinks will happen takes place, it's actually positive for Canadian Solar. As they estimate the reason is that the amount of distributed solar installations will only amount to a total of 2 GW. First, Canadian Solar primarily operates in the solar utility segment, which Deutsche thinks will strive, as Barron's pointed out in article describing the research report:
"That said, Deutsche pointed out the Chinese solar companies expect the government to continue issuing utility project licenses after the industry hits 6GW target."
This is a positive for Canadian Solar, if Deutsche is right, of course.
Second, a great amount of analysts specializing in the solar industry tend to disagree with the analysts from Deutsche. The main arguments talking against Deutsche's forecast is the seasonality of the installations. The installations tend to be back-end loaded, which means that we normally see a higher amount of installations in the latter part of the year compared to the first part of the year. A great amount of analysts argue that the 1 GW solar distributed installations in the first quarter of 2014 is mainly due to seasonality.
This often is the cause of bearish research reports at the end of the first quarter of the year. The research reports from analyst often surprisingly enough turn positive starting from mid-Q3.
It's only other analysts covering the industry that seems to disagree with Deutsche. Executives from nearly all of the listed solar companies seem to disagree with Deutsche.
The bottom line is, whether Deutsche is right or not - Canadian Solar is almost not affected.
Misunderstanding #2: The Earnings
Canadian Solar announced earnings for the first quarter of 2014 on Friday, May 16, 2014. The company's Q1 EPS was $0.01 below consensus estimates, and guidance for the full year was reaffirmed. However, what seemed to make investors panic was that the company's revenue guidance for Q2 2014 was lower than consensus estimates. This is primarily due to the fact that consensus analysts had expected that a higher portion of revenue would have been front-end loaded. But, as the company puts it:
"The Company's Canadian and U.S. project revenue recognition is expected to be back-end loaded in 2014 due to permitting and construction scheduling as well as US GAAP accounting rules which, for most Canadian projects, only allow revenue recognition after the commercial operation date (COD) and the transfer of ownership to end customers. The estimated COD of all of the Company's late-stage projects in Canada, the U.S., Japan and China is subject to change without notice as a result of delays in permitting and construction, among other risk factors. The acceptance tests and closing process will start after COD. The length of acceptance tests may be affected by the solar radiation level and other weather conditions, therefore, the close of project sales transaction may not always occur in the same quarter of COD"
So, the company's guidance for the full year still persists, which means that the expected cash flow coming in 2014 still persists. But, investors have panicked due to a few months' difference in the recognition of revenue. This means that the company's fundamentals have essentially not changed in any meaningful way.
Haven't we seen this before?
Yes, we have. Investors' reaction to the earnings announcement is exactly like the pattern that I have previously described in this article (if you haven't read it yet, read it… and then return to this article. It will make your life way easier). Short-term traders, investors and algorithms have sold off the stock following a $0.01 miss on the Q1 compared to consensus.
The investment thesis has got even more attractive
I first published my long thesis on the company about a week ago, when the stock was trading considerably higher. As the fundamentals of the company haven't changed for the worse since, the long thesis still persists. It actually makes the company an even more attractive investment at the current price, as the downside has gotten smaller compared to the potential upside. The following is a valuation summary that compares the potential upside to the potential downside, based on extremely conservative upside and downside scenarios - the upside is downplayed and downside exaggerated.
(The assumptions behind the scenarios are described in greater detail in my previous article on the company.)
As the valuation summary shows, the non-weighted reward-to-risk ratio is above 7. One has to keep in mind that this is under extremely conservative scenarios and that it's non-weighted. Under the extremely conservative scenarios and a weighting of each scenario playing out, the reward-to-risk is likely to be higher, as we have decreased the upside in our scenario, increased the downside, and the catastrophe scenario seems to be less likely to happen compared to the upside scenarios.
As the company continues to deliver on its business plan, investors are likely to realize that they have misunderstood the company, its exposure and its future potential.
The long thesis is still intact, and the shares of Canadian Solar seem very attractive at the current trading price. A long position can be established with a highly asymmetric reward/risk-ratio.