Not many companies or industries have grown at an annual rate of over 50% consistently in recent years. One might imagine Wall Street placing a higher premium on companies that have been able to maintain such high levels of growth. Market efficiency is a theory that often holds true over longer periods of time. However in any snapshot in time, equity markets can display the highest degree of inefficiency and irrationality. One prime example is Trina Solar (TSL) which has grown net income by a compound annual growth rate (CAGR) of 71.83% in the last four years since becoming a publicly listed company. For this not so minor accomplishment, Wall Street has rewarded TSL with a 6.35 price to earnings ratio (PE) based on the company’s recent share price.
For a direct industry comparison among US listed solar companies, Trina Solar’s 2010 net income of $311m only trails First Solar’s (FSLR) $664m in annual earnings. FSLR isn’t exactly a growth laggard either by any measure, posting a net income CAGR of 43.11% during the period. However, investors were far more generous toward First Solar by granting the shares a 19.50 PE.
Unlike many other peers in the solar industry, both TSL and FSLR were able to post annual earnings growth each and every year during the past four years. Despite external shocks such as the credit crisis of 2008, the global economic slow down in the following year, and in direct contrast to how other industry peers performed, both companies' consistent earnings growth was a testament regarding how well they were managed. Even outside the solar industry, TSL’s $311m in annual earnings were formidable enough to surpass DOW component Alcoa’s (AA) 2010 net income of $254m.
Trina Solar’s fourth quarter and 2010 earnings were impressive in any context. Quarterly revenues increased 26.3% sequentially and almost 105% year over year to $641.8m. Shipments crushed the company’s 300mw high end range by 51mw, up over 114% from 2009 levels. Net income on a US GAAP basis surged to $145.3m, up 75% sequentially and almost tripling year ago figures. Fully diluted earnings per share rose to $1.87, crushing Wall Street estimates $1.09 in EPS. After adjusting for non-operational foreign exchange gains, TSL still easily surpassed my estimates of $1.24 in operational EPS by $.28 per share.
On an annual basis, TSL’s 2010 shipments reached 1.06gw, up 164.8% over 2009. Due to annual declines in module average selling prices, revenues grew at a slower clip relative to shipments but were still up almost 120% year over year. As noted, net income grew to $311m, up 223.7% over 2009 as gross margin expanded to 31.5% from 28.1%. On a US GAAP level, Trina Solar’s 2010 earnings per share totaled 4.18, up from the 1.69 EPS posted in the prior year.
Unlike other top tier US listed solar companies, Trina Solar managed to gain market share in the global photovoltaic panel market last year. According to a leading solar industry research firm, Solarbuzz estimated global photovoltaic installations grew 139% to 18.2gw in 2010. Although Trina Solar’s shipment growth expanded by a blistering 165%, TSL was only able to marginally increase market share. In contrast, tier one direct peers Suntech Power (STP) grew shipments by 125%, Yingli Green Energy (YGE) by 102%, while FSLR’s production grew by less than 30% in 2010 over 2009. In other words, of the top tier panel manufacturers listed on the US exchanges, only Trina solar gained in worldwide market share while STP, YGE, and FSLR all lost market share from the prior year.
One of the main reasons why top tier module producers were barely able keep up with global installation growth was due to capacity constraints. In good or bad cycles, orders go through them first. As a result, their installed capacities were typically highly utilized. Trina Solar for example was fully utilized for nearly all of 2009 despite many peers experiencing utilization levels below 50% during the aftermath of the credit crisis and global slowdown. Only as the sheer absolute volume of global demand surpassed top tier producer’s ability to expand their own capacities were lower tier peers able to increase their own utilization levels. In essence, the law of large numbers made it more difficult for larger producers to more than double their capacity in such a short time frame.
As Trina Solar saw orders for its own products far exceed its ability to supply. The company surprised many by announcing a more flexible expansion strategy in late 2009. As many peers were slowly driven to a more integrated production strategy in order to preserve their own profitability, TSL decided to expand with less integration in order to preserve and gain market share. By using a model involving wafer procurement, the company was able to concentrate capacity expansion more toward the cell and module verticals. This integration strategy increased module shipment potential at the expense of overall gross margin since some of the gross profit would have to be given to wafer suppliers.
The same strategy also crippled the profitability of some peers since it left them with less control over procurement costs. In fact with the wafer market currently undersupplied, some companies that rely on wafer procurement experienced significant margin squeeze. Trina Solar’s decision surprised and drew concerns from many investors and industry analysts. Had one of the few solar companies in the world able to post earnings growth during post credit crisis 2009 finally made a mistake? Would this decision be the company’s Waterloo?
As highlighted in a prior article, Trina Solar is not only in the solar module business but also in the business of growing earnings. In more ways than one, its decision making has not only shielded the company from downturns but also expanded its upside potential during expansive cycles. If procuring wafers and sacrificing posted gross margin would increase overall net income and gain market share, it would be an easy decision for TSL’s management to make.
While some investors might be willing to give Trina Solar the benefit of the doubt given its incredible track record of earnings growth, there is a more analytical explanation. TSL may simply be making expansion decisions based on return on invested capital (ROIC). One factor, which may have influenced its decision, was an emerging giant in the industry - GCL-Poly.
After a failed US IPO in late 2008, it was questionable whether GCL would make any significant impact on the industry as a small polysilicon producer in China. GCL’s successful recapitalization on the Hong Kong market in mid 2009 was the turning point and provided the company with significant new resources to not only expand polysilicon capacity but also become a major wafer supplier. At the end of 2010, GCL had become the world’s largest wafer supplier by capacity from scratch in the prior year.
GCL’s strategy appeared simple. By leveraging its low polysilicon production cost structure, GCL could offer the most competitively priced wafers in the industry. Its value proposition is further enhanced by a co-location strategy with customers to reduce additional incremental costs such as shipping and handling. Even during the third and fourth quarter of 2010, when wafer supplies were extremely tight, GCL’s wafer average selling prices were .80/watt and .82/watt respectively. Spot market wafer pricing during the same period ranged from .90-1.00/watt. Aggressive pricing steered many top tier players in the solar industry toward GCL, including TSL’s recent large polysilicon and wafer contract amendment concluded earlier this year.
With Trina Solar’s stated metrics in its fourth quarter earnings report along with GCL’s wafer pricing, simple ROIC can be calculated. For internally produced wafers, TSL stated unit costs were 1.16/watt in the fourth quarter. Considering fully integrated capital expansion costs have dropped significantly in recent years, .55/watt (down from .80-1.00/watt) wafer to module expansion costs should be consistent with metrics today. Also using TSL’s annualized metrics, .20/watt in operating and tax expenses were deducted from gross returns. The result was a staggering 84% estimated ROIC on the company’s fully integrated expansion costs.
Under market pricing before GCL’s introduction, ROIC for just the cell and module vertical would have been lower than TSL’s fully integrated metrics. GCL’s extremely low pricing tipped the scale. GCL’s low wafer pricing for its large customers combined with capital costs for just the cell and module vertical produced an even more astonishing 94% estimated ROIC for Trina Solar.
With a large and low cost co-located supply of wafers from GCL, TSL’s decision on a more flexible integrated expansion strategy away from a fully vertical model appeared to be an easy decision. Using this path, the company could generate higher earnings growth through higher ROIC. For an industry so heavily capital intensive and at periods access to capital deficient, proper capital expansion was critical in generating the highest returns for shareholders. In addition to higher earnings potential, this strategy also allowed Trina Solar to capture higher market share by allocating more capital to downstream verticals. For investors seeking absolute net income growth and market share gain, TSL appeared to have made the right decision.
As also seen with many direct peers, Trina Solar may experience some short term margin pressure heading into the first quarter of 2011. In its Q4 2010 conference call, TSL stated that orders remained extremely strong at double the company’s production capacity. The company was selecting business with only the highest tier among their customer profile. As a result, Trina Solar’s shipment guidance should be extremely reliable especially given the fact it has often beaten its own guidance by wide margins. Pricing at both the cost and selling side can be more wide ranging however.
Although Trina Solar is not a spot market player, unexpected high volume of orders caused the company to turn to the spot market for portions of its procurement not already covered by long term contracts. Until higher volumes of long term contracted supplies reduce spot market exposure, TSL’s blended unit costs could be higher than normalized levels much like the situation with JA Solar (JASO) detailed in a prior article. Much like JASO, Trina Solar also expects costs to trend down in the second quarter. Profitability metrics may thus be at a trough in the first quarter.
Based on Trina Solar’s stated metrics as well as those derived from its comments, TSL’s first quarter 2010 earnings have been compiled below. These estimates only account for the company’s operational earnings:
TSL Q1 2011 Earnings Estimate:
Unit Costs: 220 x 1.16 = 255.2m, 135 x 1.35 = 182.3m, 15 x 1.55 = 23.3m
Blended Unit Costs: 461m / 370mw = 1.245/watt
Gross Profit: 655 - 461 = 194m
Gross Margin: 194 / 655 = 29.6%
Operating Costs: 56m
Net Interest Expense: 6.5m
Net Income: 113.5m
Diluted Share Count: 79m
For the first quarter, there should only be one variable, which may be a large factor in TSL’s US GAAP results. Foreign exchange translations, which can typically play a large role in the company’s reported earnings have been left out of the estimates above. With almost two weeks of currency trading left in a very volatile forex market, it is impossible to know exactly where currencies will close the quarter. Normally a strong euro has been good for Chinese based solar companies, which have high exposure to EU markets. After the euro’s dramatic fall in 2010, many solar companies began forward hedging against the euro to reduce exposure to a weak euro. Trina Solar was among those that began forward hedging against the euro.
With the euro up over 5% vs. the usd so far in the first quarter and assuming TSL did not change currency hedging practices, the company may post a large net foreign exchange loss. The loss could be as high as 60m based on recent exchange rates. As a result, this loss could impact TSL’s US GAAP earnings by as much as .75 in EPS. Each 1% the euro appreciates vs. the usd may increase net foreign exchange loss by .15 in EPS. The converse would also be true if the euro declined against the usd in the remaining days of the first quarter.
It is important to keep in mind that currency translations normally balance out in longer time periods if key currencies remain range bound. In any given quarter, currency can impact overall earnings by large percentages but over the course of an entire year normally cancel each other out. For example, foreign exchange translations were large in each of TSL’s quarterly earnings in 2010, but the net impact over the course of the fiscal year reduced to around 8%.
Lastly, while Trina Solar only gave a shipment guidance range of 1.75-1.80gw for 2011, it is still possible to estimate annual earnings per share. Based on comments TSL made in its last conference call, the cadence of the company’s shipment growth rate roughly equal the cadence of declines in cost and average selling prices throughout this year. As a result, operational results posted in the first quarter of 2011 could to an extent be annualized over the course of the year with a margin for error around 10%. Additionally assuming net foreign exchange translations average out to historical impacts, annual operational results may be further impacted by another 10% in either direction barring any large one directional move in the currency markets for the entire of 2011. Based on these parameters, Trina Solar should be able to post an annual EPS growth rate anywhere from 10% to over 50% in 2011.