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During the course of 2010, investors have continually fretted that the solar power industry was headed for severe slump. They worried that too many new factories were set to produce far more solar panels than the industry could absorb. And that supply increase was coming right at a time when demand was set to fall. European governments had been the key behind robust global demand in previous years, but massive budget pressures would likely force them to throttle back incentives.

Despite those dire concerns, 2010 will likely turn out to be a banner year for the industry, with global solar spending set to more than double, according to UBS. Firm demand means that suppliers did not need to embark on profit-sapping price wars, as many had feared. As a result, the 10 largest publicly-traded solar plays exceeded sales forecasts in the June quarter, and all raised guidance for the second half of 2010.

One of the benefits of firm demand is that expected price cuts haven't materialized. Yet the industry had been preparing for the worst by enacting steady cost reductions. Lower costs and firm prices translates into stable or rising profit margins, which is just what we are seeing in recent industry quarterly reports. Sector share prices have rebounded from their spring lows, but they still have more room to run.

To be sure, the industry is in flux. Germany, which had been the biggest buyer of solar equipment, is likely to start spending less in coming years. And don't be surprised if a few new growth markets such as the Czech Republic start to disappoint on the heels of budget pressures. But elsewhere, especially in the United States, demand is really kicking into gear. As this table shows, the U.S. should emerge as the second-leading buyer of solar equipment by 2012 in terms of GigaWatts (GW) of power.

Rank 2010 2012 GW in 2012
1 Germany Germany 7,000
2 Italy U.S. 2,260
3 U.S. China 2,180
4 Japan Italy 1,725
5 France France 1,127

Industry bears will note that Germany is such a strong consumer of solar power than any change of heart could devastate industry demand. But Barclay's Vishal Shah predicts those concerns will eventually abate. In a recent report, he noted that a number of countries such as Canada, the U.K. and other countries across Europe, are likely to increase their solar power subsidies in 2011, adding that "we expect demand to exceed supply during this second growth-phase."

The industry's brightening prospects come at a time when fossil fuel prices are well off their 2008 highs, when oil exceeded $140 a barrel, and natural gas prices surged in tandem. Many thought the solar industry would only thrive if energy prices were high or carbon emissions were heavily taxed. So if either of those factors comes into play, then demand for solar could well be sustained at high levels into the middle of the decade.

The picks
As noted earlier, sector shares have rebounded from their lows but remain below analyst target prices. Several analysts cite Yingli Green Energy (NYSE: YGE) as a favorite current pick. The China-based supplier of solar modules has established a low-cost manufacturing base that is leading to rising market share. Sales are expected to rise more than +50% this year to around $1.6 billion, and consensus forecasts of around +11% sales growth in 2011 looks too conservative now that industry prices are no longer falling. Shares trade for about 11 times next year's consensus profit forecast, and that profit outlook also looks understated.

For many investors, First Solar (Nasdaq: FSLR) represents the strongest business model in the sector. The company is the global leader in the production of thin-film solar, which captures less of the sun's energy than traditional silicon-based solar panels, but can be made far more cheaply and also can be deployed in a wider variety of applications. Over the years the company has managed to steadily cut production costs, pushing prices below levels where rivals could make money, even if those rivals' technological approach yielded more energy from each solar panel. In 2007, the company was able to build modules for roughly $1.40 per watt of power. That figure breached the $1 mark late in 2008, and recently hit $0.76. The company now spends roughly $100 million per year on research and development to achieve this kind of efficiency.

That leading-edge approach led to fast-rising market share. Sales doubled or tripled every year from 2003 to 2008, and are still rising in excess of +20% every year. Moreover, a shift in the business model toward the development of massive solar power farms is leading to an apparent reduction in gross margins -- so per share profits are likely to be flat this year. It's also a result of accounting methods, but the company's current major projects should yield robust cash flow in a year or two.

Shares of First Solar don't likely possess massive upside, but they should see steady, moderate gains as the solar industry progresses in coming years. Any major pullback in the stock would represent a compelling buying opportunity. Shares have had a habit of bouncing between $100 and $150 during the past year. Right now, they are at the upper end of that range, so you may want to wait for a pullback before pouncing.

The bottom line is that this industry's obituary has been prematurely written. Many of these stocks have moved back toward their 52-week range, but the next move could be a break-out through that 52-week range. The key catalyst for this group in 2011 is either a spike in fossil fuel prices or further progress on carbon tax legislation.

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.

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Source: Don't Miss the Comeback in Solar Stocks