Canadian Solar's Q2 Control Problems in the Midst of Vertical Integration

| About: Canadian Solar (CSIQ)

Canadian Solar’s (NASDAQ:CSIQ) overall shipments decreased in the second quarter of 2010; however the number of solar cells produced increased, as the company is relying less on third party purchases to fill customer orders. Revenue was down slightly in the second quarter 2010, but the company’s gross margin and net income margin improved. The company expects gross margin to improve as third party product purchases decrease. Third quarter 2010 guidance includes improving the gross margin from 13.6% in the second quarter 2010 to a projected range of 14.5% to 15.5%. The company does not provide a statement of cash flow on a quarterly basis. We calculated a positive operating cash flow for the company in the second quarter 2010. Improved receivables collection helped to achieve the company’s first positive operating cash flow in the last six quarters.

The company ranks in the bottom half of its peer group on six of the eight quantitative metrics. The company ranks 24th in operating cash flow to net income for the last-12 months based on our calculations. The company’s limited cash flow from operations in the last 12 months negatively impacts the company’s free cash flow to net income and cash conversion cycle ratios. As the company relies more on internally produced solar cells the company’s low ranking of 25th for gross margin for the last 12 months should improve. The company uses short-term debt as its main source of financing; however, the company did issue 6.9 million shares of common stock in fiscal 2009 that raised over $100 million. The debt-to-equity and cash-to-debt ratios rank favorably in the industry at number 18 and 9, respectively.

The company provides very limited information in its quarterly filings. The company is downgraded to D’s for governance and disclosure due to material weaknesses in the company’s internal controls. The company disclosed it is in the process of correcting the control deficiencies, but “cannot assure you that the material weaknesses identified in this annual report will be adequately remedied or will be fully remedied by any specific date.” In addition the company’s material weaknesses caused the company to miss its Form 20-F filing deadline for the fiscal year ended Dec. 31, 2009.

Based on our calculations, the company’s cost per watt was above the industry average for five of last eight quarters. The company’s cost per watt shipped went down slightly in the second quarter 2010 dropping to $1.57 per watt compared to $1.59 per watt in the first quarter 2010. The trend of declining cost per watt started at the end of fiscal year 2008 when the company had a cost per watt shipped of $5.01. The company experienced a 7.6% drop in the cost per watt calculation in the first quarter 2010 compared to an industry average of a 41% decline in the same period. A sizeable amount of the company’s shipments are third party solar cell purchases. The company’s limited disclosure of costs of third party purchases to fulfill customer orders makes it difficult to determine the reason the company did not experience the same decrease in the cost per watt metric as its competitors.

The company shipped 181.2 MW of solar cells in the second quarter 2010 compared to 185 MW in the first quarter 2010. While the company shipped 2.1% less in the second quarter 2010; it produced 18.3% more solar cells in the second quarter 2010. The 110 MW of internally produced solar cells marks a change in philosophy in the company’s strategy to rely less on third party purchases to fill the remaining balance of shipments. In the second quarter 2010, 60.7% of the MW shipped was produced internally compared to 50.3% in the first quarter 2010. Going forward the company’s guidance shows an increase of 15% of produced cells in the third quarter 2010 and a 63.6% increase by the end of fiscal 2010. The percentage of produced solar cells to the quarterly shipment should be close to 90% by the fourth quarter 2010

The company disclosed on July 31, 2010, the company had total solar module capacity of 1.3 GW, solar cell capacity of 420 MW, 300 MW of ingot capacity, and a wafer capacity of 150 MW. The company produced only 110 MW of solar cells in the second quarter 2010. Calculating capacity utilization using the company’s 1.3 GW of solar module capacity equates to a utilization percentage of only 33.8% in the second quarter 2010. Using the solar cell capacity of 420 MW produces a more reasonable utilization percentage of 104.8% for the second quarter 2010, a 162 basis point improvement over the first quarter 2010.

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