JA Solar (Nasdaq: JASO) is set to post a record quarter when it reports its Q4 2010 earnings next week. In fact, it should mark a record year across numerous metrics such as shipments, revenues, and most importantly, net income.
None of this should be a big surprise given the extremely strong quarter that the company posted in Q3, in which they earned .47 in earnings per share. As witnessed in recent quarters, JASO under-promised and over-delivered as they posted results well above their own guidance. As a result, their third quarter earnings also surpassed my estimates since I keep my analysis within the parameters given by the company to avoid unnecessary speculation.
Operating metrics for the company accelerated significantly for the third quarter. Shipments increased 34% sequentially to 418mw from 311mw recorded in the second quarter as global demand outstripped supply. As noted by JASO’s peer group, the company operated at full utilization and continued to see demand surpass their capacity to supply products. Revenues increased at a larger 52% sequential clip over the second quarter due to slightly higher cell selling prices as well as increased module shipment mix which carry higher selling prices.
Excluding one time charges related to a legacy supply contract, JA Solar’s operating expenses increased at a lower pace from 18.2m in the second quarter to 21.9m in the third quarter. Economies of scale, as well as the company’s operating structure of providing OEM rather than branded products, were the primary reasons for the company’s operating margin expansion despite a slight gross margin contraction due to higher procurement costs and product mix shift. On a US GAAP basis, the company’s earnings increased sequentially from .18 per share to .47 per share for Q3 2010.
For the fourth quarter, JASO guided for shipments around 450mw which would represent approximately a 10% sequential increase. It also represents full utilization of the company’s stated 1.8gw capacity. Thus unless the company again underestimated their own guidance, a large shipment surprise as seen in the third quarter is unlikely to repeat.
Due to the pull-in effect as customers try to get installations completed by the end of the year and ahead of the feed in tariff cuts at the start of 2011, prices for solar products rose across all verticals. JA Solar not only noted a high single digit increase in asps for their products, but also in their procurement costs. This is a bit surprising given the company’s low spot market exposure at both ends of the business spectrum. The overall net effect should be a slight relative increase in revenues per shipment volume while gross margins remain flat or trend down slightly.
Although operating expenses generally should not increase as fast as revenues given JASO’s operating structure, the fourth quarter is the last quarter of the year which usually results in end of year bonuses that could inflate operating costs slightly.
Other non-operating items should more or less cancel each other out and be a very small effect on the company’s earnings on an absolute dollar basis. As explained in my prior article, JASO should record a small derivative gain given the company’s share price declined during the quarter by a fair degree. Although this line item is almost impossible to estimate accurately, it should roughly equal in magnitude the losses reported in the prior quarter.
In addition, the key foreign exchange driver is the euro vs. usd relationship. For the fourth quarter, the euro lost slightly over 2% vs. the usd which will generally result in forex losses for most Chinese based solar companies such as JASO. Given their sales mix however, these foreign exchange translations are much smaller than similar peers. They are also slightly offset by the rmb gain vs. the usd which will result in gains for the company as they have convertible bond debt denominated in usd.
The company also noted it will record a 34.6m one time gain due to recovery of investment losses linked to their Lehman bankruptcy exposure in 2008. The general result of these combined non-operating line items will generate a US GAAP benefit of around .20 in earnings per share. Thus to get a better comparison of the company’s results, it’s best to exclude this amount from the US GAAP estimate given below.
- Revenues: 605m
- Shipments: 270mw cell, 80mw tolling, 100mw module
- Asps: 1.40/watt cell, .45/watt tolling, 1.80/watt module
- Unit Costs: 1.10/watt cell, .23/watt tolling, 1.50/watt module
- Gross Profit: 270 x .30 = 81m + 80 x .22 = 17.6m + 100 x .30 = 30m
- Incremental Gross Profit: 30 x .15 = 4.5m wafer
- Gross Margin: 81m + 17.6m + 30m + 4.5m = 133m / 605m = 22%
- Operating Expenses: 25m
- Net Interest Expense: 8m
- Derivative Gain: 5m
- Foreign Exchange Loss:3m
- Lehman Investment Recovery: 34m
- Tax: 21m
- Net Income: 115m
- Share Count: 165m
- EPS: .70
Looking forward into 2011 is more challenging. JASO’s main vertical, cell production, experienced the highest degree of capacity expansion during the boom last year. As a result there appears to be clear cell overcapacity unless overall global demand surpasses 22-25gw range this year. Most current projections peg 2011 solar cell demand between 15gw and 20gw (Barclays Capital, Roth Capital, IMS Research, iSuppli). The first indication of an oversupplied market is the recent drop in the spot market average selling prices for solar cells.
In a recent article, Digitimes, a reliable and accurate source for solar industry information, noted that cell asps dropped below 1.20/watt last month, down from 1.40-1.50/watt in the prior quarter. PV Insights, who keeps track of average weekly spot market trends has also confirmed the recent price drop. At face value this indicates pv cell producers who operate solely at spot market pricing could see asps declines of over 20% sequentially which could also result in gross margin being cut in half under extreme scenarios.
Since si-pv cell production is still the core of JA Solar’s business, it’s easy to misinterpret how the recent pricing trends will affect the company. To be sure, JASO’s per watt gross margins will compress as generally the case for the entire industry, but the company does differentiate from most other single vertical cell producing peers.
JA Solar does not operate at the spot market on either spectrum. They procure most of their wafers from long term contracted pricing which generally are discounted vs. spot market pricing. The company also sells to larger higher tier customers at generally contracted pricing below spot market pricing. As a result, the company’s business is not as affected by spot market trends on the same level of magnitude. JASO also does much of its business with key industry players. Less middlemen are involved which translates to lower module end prices that use JASO’s cells. Lower end product pricing will increase the likelihood it gets consumed within the industry value chain. In addition, the company has also expanded downstream integration by adding module capacity.
In the past, JASO would refer to tolling partners who would then process the company’s cells into modules for their customers. Offering that service to their existing customers reduces the number of steps involved and again results in lower end module costs. Many of JA Solar’s customers are top industry players such as BP Solar and MEMC who possess the ability to consume modules in their downstream systems divisions rather than resell them through distribution channels. In undersupplied markets such as what the solar industry enjoyed last year these factors do not make a big difference, but if the overall solar industry enters into an oversupplied situation this year these factors can determine who has the ability to sell out capacity and who doesn’t.
Since JA Solar, along with Suntech Power (STP), have the largest cell capacity in the world, scale, and thus economies of scale, are on their side. While they are not as fully integrated as Yingli Green Energy (YGE), their scale, production efficiencies, and strong industry relationships should put them ahead of many peers. Because JASO is not fully integrated, they will never enjoy industry leading gross margins seen by fully integrated peers. However the company’s cost metrics are still efficient enough to produce a fair level of earnings despite the magnitude of per watt gross margin contraction the industry may encounter this year.
Based on the pricing trends today, JASO’s per watt gross margin for cells will likely compress from the high .20s/watt to around .20/watt this year. That translates to around a 25-30% gross margin contraction on a per watt basis. As a result in order to maintain similar of gross profits, shipments must rise by a slightly higher degree. Unless JASO can guide 2011 shipments above the 2gw range, it’s possible the company’s earnings stay relatively flat from Q4 2010’s annualized earnings.
This means that whatever results JASO reports for its fourth quarter 2010 will likely represent peak metrics for the intermediate term. That’s not necessarily a bad thing because .40-.50 quarterly earnings per share annualized is 1.60-2.00 for the year - a fairly high degree of earnings relative to an 8.00 stock based on recent stock pricing.
2011 should still represent a year of moderate annual earnings per share growth for JASO, but on a sequential basis the next few quarters may stay relatively flat when gauging absolute net income. Higher than a 2gw annual shipment guidance should keep sequential earnings improvement intact however. JA Solar has yet to give general guidance for 2011.