China Sunergy (NASDAQ: CSUN) is the smallest of the US listed Chinese solar companies and currently only operates in cell production vertical. At face value, their Q2 earnings (see earnings call transcript here) were quite good. Revenues soared 107% year over year and 23% sequentially to 117m. Earnings were also up significantly as gross margins expanded to almost 20%. Earnings on a per share basis totaled .33 on a diluted EPS basis, compared to .18 EPS reported last year. Not bad for a four dollar stock if they can keep these levels of earnings stable over a longer period.
The advantage of operating in a single vertical is that during boom cycles, CSUN’s level of earnings can look extremely good as they leverage their lower cost structure to meet periods of high demand. The disadvantage of operating in a single vertical is that during down cycles, margins may compress because they don’t have direct control over end sales. CSUN will always rely on the ability of their customers who produce modules to do well. Higher integrated module producing peers have more direct control over costs as well as end demand exposure. As a result, even during down cycles, the level of their business doesn’t fluctuate as wildly as for CSUN. In recent years, CSUN’s quarterly earnings have swung from one extreme to another while some peers have kept their earnings more on a consistent level. The company is in the process of acquiring their sister module manufacturers CEEG (Nanjing and Shanghai), but has experienced delays in completing the merger. If and when this deal is closed, CSUN will operate more as a two vertical module manufacturer much like their larger peer Suntech Power.
For now however, the industry is experiencing high demand and prices across all verticals are strong. CSUN operates more at the spot market level, so their metrics can swing rather wildly. Currently the demand for both wafers and cells are strong. Despite having to pay higher spot pricing for wafer procurement, CSUN can still keep per watt gross margins stable by selling cells at spot market pricing. It’s not the best position to be in since some companies may be able to procure supplies at lower contracted prices while selling finished goods at higher spot market pricing, but it’s good enough in this environment for CSUN to continue to produce a high level of earnings relative to it’s stock price.
One issue that is now limiting the company’s growth however has been their conservative expansion over the past couple of years. Despite booming demand that was evident over a year ago, CSUN has kept their capacity at levels nearly that of two years ago. As a result, their shipments will be constrained while many peers will be doubling their shipment volumes. The company may not be able to increase cell production by any significant degree until early next year when new capacity comes online. For the second quarter as an example, the company had to draw down inventory to achieve higher shipments. This may not be as feasible given their current inventory levels for the current quarter, and thus they will be hard pressed to increase cell shipment levels sequentially. Limited module shipments may increase in contrast which relies on purchased cells.
Combining all of these factors together, CSUN can expect to post similar sequential results. I estimate cell shipments to be constrained to around 83mw production levels. Although wafer pricing may increase more on a per watt basis over cell pricing, CSUN’s blended wafer costs for Q3 will not rise to the same degree. As a result, they should be able to keep per watt gross margins stable if not slightly increase it if they are able to sell their cells at the higher end of quoted spot market ranges. As with anyone purchasing cells, gross margins for cell procured module production will be next to nil. In my estimates, I factor in zero margins to be conservative but this really isn‘t a factor since their module volumes are extremely small. CSUN’s Q3 results may look something similar to:
Shipments: 83mw cell, 4mw module
Asps: 1.36/watt cell, 1.70/watt module
Unit Costs: 1.09/watt cell, 1.70/watt module
Gross Profit: 83 x .27 = 22.5m
Gross Margin: 18.7%
Operating Expenses: 6m
Net Interest Expense: 2m
Net Income: 12.5m
Share Count: 44m
Although currency was favorable for the sector as of today’s exchange rates, I did not factor possible currency gains. In CSUN’s case since they have very limited euro exposure, any currency gains would be rather small. Another factor that may affect their earnings is an ongoing legal dispute with REC over a long term wafer supply agreement signed back in 2008. Since then, wafer prices have dropped by more than 50% and it appears the two companies could not come to terms on renegotiating pricing levels. From quarter to quarter, CSUN may experience higher operating costs because of legal expenses. Since it’s not factored in the estimates above, legal expenses could reduce the company’s profitability levels. In addition, the magnitude of this legal dispute is a 50m prepayment. If judgment is ruled against CSUN, they could be forced to take as much as a 50m charge which would be a significant impact on an EPS level - 1.15 EPS loss. Outside of these factors, the current market trend would indicate CSUN producing a similar level of earnings for the fourth quarter of this year. The closing impact of their intended acquisition of the targeted module manufacturers could also add incrementally to earnings.
Disclosure: No position in CSUN or STP.