China Sunergy (NASDAQ: CSUN) recently reported fourth quarter and fiscal 2010 earnings that were generally in line with what Wall Street expected. CSUN’s strong earnings were no exception to the incredible year that the entire solar industry experienced in 2010. Looking ahead, their comments on near term margin compression was not a big surprise either given the recent pricing spread between the company's verticals. Not a stranger to ambiguity, China Sunergy also presented information that left both investors and analysts with more questions than answers.
First the good news: Earnings remained very strong for the fourth quarter of 2010. Revenues jumped from 116.8m to almost 170m sequentially as the company’s product mix shifted to modules and away from solar cells. Shipments were strong at almost 98mw, up from 88mw in the prior quarter. The company expanded gross profits to 27.1m from 25m recorded in the third quarter. However, net income came in flat due to higher operating expenses associated with their newly acquired module vertical.
On an earnings per share basis, CSUN reported Q4 EPS of .37, ahead of analysts consensus of .33 in EPS. While their net income of 15.4m was only slightly off my estimates of 16m, a lower share count assumption caused my estimates of .40 to be too high.
On an annual basis, China Sunergy’s 2010 was dramatically improved over 2009. Revenues soared over 81% higher from 285m to 517m. While the company’s product mix was slightly different, total shipments grew from 194mw to 348mw, or a 79% annual increase. The largest year over year gains were realized as CSUN posted a net income of 51.7m, reversing 2009 losses of 10.3m. On an earnings per share basis, China Sunergy posted an EPS of 1.26, making their 4.00-4.50 recent share price seemingly attractive.
Now for the not so good news: China Sunergy’s metrics were not as strong as they should have been during 2010. While the company’s shipments were strong at 98mw in the fourth quarter, CSUN was the only US listed Chinese solar company to miss their own shipment guidance of 102-108mw. With the quarter halfway completed at the time of their guidance, investors should question how much of a grip the company has on their own business visibility. With most peers selling out anything they could produce in a white hot market, CSUN’s shipment shortfall suggest possible weakness in their own sales channel during the back half of the quarter.
In a recent Solarbuzz report, the research firm estimated that global solar photovoltaic installations grew by a blistering 139% in 2010 over 2009 figures. China Sunergy, however, only grew their shipments by 79%. In short, the company lost market share as their small 2.6% share shrank further to 1.9%. Much of the company’s shipment growth came from higher utilization levels of already installed equipment. During 2009 and 2010, when some direct peers doubled or tripled their shipments, China Sunergy chose to keep their installed capacity steady at 320mw during 2009 while only expanding it to 400mw last year. Again, investors should question whether the company was prudent or just missed a golden opportunity during a huge boom year for the industry.
On to the bad news: CSUN’s business prospects are worsening in the near term. As mentioned in my prior article, the recent pricing spread between China Sunergy’s main verticals did not appear favorable. With the company so heavily exposed to the spot market, I cautioned that their gross margin could fall to 10% or possibly even lower, from the 16% gross margin I estimated for their fourth quarter 2010. In the company’s earnings report, China Sunergy affirmed a sequential margin squeeze:
The Company expects its gross margin for the first quarter of 2011 to be approximately between 9%-10.5%.
While their margin compression isn’t extreme enough to generate losses, it will cause the company’s net income to fall dramatically on a sequential basis and easily miss current Wall Street Q1 2011 estimates of .25 a share.
As a lower tier module supplier heavily exposed to the spot market, China Sunergy’s profitability will be heavily dependent on their material procurement, namely silicon wafers. Unfortunately, the company’s conference call did not provide much clarity. At least half of their wafer procurement were classified as spot market or contract rates linked to spot market pricing.
Until the majority of their wafer procurement is supplied by their large GCL contract, CSUN’s margins could remain under pressure under the current pricing spread between their procurement and sales verticals. Their comments also suggested that volumes from GCL may be back end weighted. This could mean that margin improvement might not come until the second half of 2011, assuming average selling prices don't decline to a greater degree.
Finally, the ugly part of China Sunergy’s recent earnings report: It was hard to reconcile some of the company’s past actions and statements. First, some of the operating metrics provided by the company (as analysts drilled management repeatedly for more detailed responses) simply didn’t make sense.
For example, CSUN’s estimated wafer procurement for the first quarter is .92/watt, and their cell and module processing costs are .22/watt and .41/watt respectively. With a stated asp of 1.70/watt, it’s impossible to see how the company can generate 14-15% “integrated (cell/module)” gross margin. These metrics would yield under 10% gross margin for their highest gross margin business segment. However even if CSUN’s integrated gross margin came in at 14-15%, the rest of their businesses would have to generate near zero margins for the company’s blended gross margin to range between 9-10.5%.
The reasons why CSUN would have such a wide disparity between integrated margin and cell procured margin is also hard to comprehend. With a stated cell capacity of 400mw and module shipments not much higher, over 90% of their shipments should come from integrated capacity. Yet the company guided for integrated shipments to be around 70%, indicating underutilization of their cell capacity for two consecutive quarters.
Despite 650mw of contracted orders for 2011, CSUN is still considered a second tier provider. In an environment of excess supply, the quality of lower tier contracts can come into question. In contrast to extremely low capital expenditures for both 2009 and 2010, when demand exceeded supply for much of this two year period, China Sunergy plans to embark on their most extensive capacity expansion in the company’s history this year. For 2011, the company plans to spend 130m on capital expenditures, which would more than double their fixed asset base.
No one would question such a large expansion plan a year ago, but when current spot market pricing already reflects a potential oversupply in China Sunergy’s two key verticals, their management’s timing has to come into question. First tier direct peers such as Trina Solar (NYSE: TSL) have already suggested an oversupply potential in 2011. Industry shipment leader Suntech Power (NYSE: STP) also made similar comments recently. If overall global demand remains large enough to encompass second tier capacity, then CSUN’s orders may be secure. However, in an already tightening market, their aggressive debt financed expansion strategy, especially for a newly acquired module segment, incurs a lot of risk uncertainty.
Finally, the details of China Sunergy’s recent acquisition of their two sister module producers should raise eyebrows. The purchase price of 46m is roughly double the capital costs to install CEEG(s) 480mw of module capacity. In fact, CSUN’s balance sheet showed that almost half of the purchase price was made up of intangible assets and goodwill.
In addition, significant debt from the acquired units was also transferred to CSUN. Total short and long term debt rose from 147m to almost 214m in the fourth quarter. Total net cash to debt ratios changed from a 33m net cash balance in the third quarter to a 22m net debt balance in the fourth quarter. While the acquisition could still pay nice dividends for the company moving forward, the terms of the transaction should be enough to cause shareholders to wonder if they received the best deal possible. After all, China Sunergy and CEEG share the same chairman.
As mentioned, it’s quite hard to reconcile the operating metrics China Sunergy offered for the first quarter of 2011. Some of the information provided have to be off relative to other data points in order to fit CSUN’s overall guidance. At this point, however, it’s difficult to estimate which metric provided by the company is the least reliable. Quite frankly, the following estimates for China Sunergy’s first quarter 2011 earnings give the company the benefit of the doubt. If pricing dynamics are more reflective of current market rates, CSUN could very well post earnings lower than the estimates provided below.
CSUN Q1 2011 earnings estimate:
- Revenues: 178m
- Shipments: 105mw module @ 1.70/watt
- Unit Costs: 80 x 1.50 = 120m + 25 x 1.60 = 40m
- Gross Profit: 178m - 120m - 40m = 18m
- Gross Margin: 18m / 178m = 10.1%
- Operating Costs: 10m
- Net Interest Expense: 2.5m
- Foreign Exchange Gain: 1m
- Tax: 1m
- Net Income: 5.5m
- Diluted Share Count: 43.7m
- EPS: 0.13
Although CSUN's Q1 2011 may show a significant sequential net income decline, it may also mark a trough in their 2011 earnings. As long as the company can increase shipments sequentially, and assuming current market spreads between CSUN's key verticals do not compress further, the company should be able to keep quarterly net income around Q1 levels, if not higher. On an annualized basis, China Sunergy isn't expensive at current levels. However, investors betting on 2010 numbers repeating may be disappointed.
As a final note, investors need to keep in mind that China Sunergy’s legal dispute with REC, over a 50m bank guarantee (linked to a prepayment for a wafer contract made in 2008), has not been finalized. In a recent press release, CSUN updated the status of this case, which will now be held in June of 2011. The original case was already ruled against CSUN. If they lose their appeal, the company may take some or all of this amount as an earnings charge.