Insights on Yingli Green Energy's Q1 and 2011 Gross Margins

| About: Yingli Green (YGE)

Yingli Green Energy's (NYSE:YGE) recently released first quarter 2011 earnings were just a formality after the company's recent pre-announcement. As previously warned, shipments dropped in the low-teens percentile from the fourth quarter to an estimated 305mw. Revenues as a result declined to $527.3m from $616.1m sequentially. Net income also declined quarter over quarter to $56.2m from $84m, but were still up 93% on an annual basis. Fully diluted earnings per share ("EPS") was .35 in Q1 which was below Wall Street consensus of .39 in EPS. On an operational level excluding a $9.3m foreign exchange gain, Yingli's Q1 EPS was .29 which exceeded my revised .26 EPS estimate. Once again it appears on average the analysts covering Yingli did not revise estimates to fully reflect the company's pre-announcement.

Yingli's earnings did reveal a few surprises. Notably, YGE's report gave insight on the unexpected decline in the company's gross margin. Like similar direct peers such as Trina Solar (NYSE:TSL), Suntech Power (NYSE:STP), Canadian Solar (NASDAQ:CSIQ), and Jinko Solar (NYSE:JKS), Yingli's gross margin for its core module sales came under pressure due to declines in average selling prices ("ASP") as well as continued near term strength in cost components such as polysilicon. Gross margin for internally produced modules declined to 30% from around 33% in the prior quarter. However, YGE's consolidated gross margin dropped further to 27.3% as a result of increased cell procurement.

The difference between the company's core module gross margin and consolidated gross margin was a big surprise since it implied YGE procured a significant volume of solar cells to supplement its manufacturing requirements. Although exact figures were not disclosed, derived estimates based on the spot market pricing spread between solar cells and modules in the first quarter suggests YGE may have procured as much as 50mw of solar cells during the quarter. As a fully integrated module producer with a long history of superior manufacturing track record, this was shocking because it suggested potential issues in the company's overall production capacity.

Yingli ended 2010 with a nameplate capacity of 1gw including 300mw of dedicated high efficiency mono-crystalline n-type capacity dubbed "Panda." In the past, YGE has had a proven ability to produce well above its nameplate capacity by over 30%. If fully utilized, the company's effective capacity during Q1 2011 could have been as high as 1.3-1.4gw on an annual basis, or 325-350mw on a quarterly basis. With an original shipment guidance around 350mw for the quarter and actual shipments around an estimated 305mw, Yingli should have had enough capacity to fulfill its demand requirements with internal manufacturing.

Why did YGE procure enough solar cells to dilute their internal gross margin by almost 3%? Part of the reason was indirectly explained in the company's earnings conference call. When asked how much of the company's new Panda line was produced during the quarter, Yingli replied around 45mw. This was below YGE's quarterly Panda nameplate capacity of 75mw, or as much as 100mw based on the company's historical production capabilities above nameplate. In other words, despite Panda's third quarter of operations since initial ramp in mid-2010, Yingli's next generation production line was only running at around half capacity.

Nevertheless, Yingli's Panda production performance since inception just three quarters ago is a huge success especially when compared to Suntech's Pluto line originally unveiled in late 2007. Despite originally commercially deployed in 2009, STP only produced 50mw of Pluto cells in 2010 and production expectations of 200mw this year. In contrast, YGE produced 66mw of Panda in just two quarters last year and has guided 2011 production targets above 400mw.

China Sunergy (NASDAQ:CSUN), another U.S. listed Chinese solar company, also talked about commercializing n-type cells since its IPO in 2007 but continually delayed launch schedules apparently due to issues commercializing it on a larger scale. In its recent 2010 annual report, CSUN dropped all mention of n-type cell development. Granted, Yingli never disclosed Panda's actual quarterly ramp schedule. Compared to its traditional multi-crystalline line which only took one quarter to fully ramp, Panda's progress appears much slower although not entirely unexpected given the newer technology involved. With Panda capacity potentially less than half utilized, Yingli's quarter production capacity easily fell below 300mw.

Another potential cause for Yingli to procure solar cells in such volume is due to the company's demand outlook. Based on its original guidance, YGE expected first quarter demand at around 350mw. Much like similar China based first tier peers, Yingli would have to operate at full capacity to satisfy demand. Outsourced solar cells was required to supplement internal Panda cell production shortfalls in order to keep the company's module capacity operating at full capacity.

Since the root of Yingli's earnings pre-announcement materialized late in the quarter after Italy announced changes in its feed in tariff ("FIT") policy in March, much of the company's external cell outsourcing may have already taken place. Yingli along with Suntech and Trina Solar are considered the top Chinese tier one brands. Much of YGE's sales are directed towards higher tier customers such as large regional distributors and project developers. For volumes dedicated for solar projects, shipments might not be able to be rerouted if developers delayed project schedules. Had Yingli rerouted shipments to other regions, there would be supply shortages once projects were resumed.

Despite the current general oversupply situation in the solar industry, demand for low cost highly bankable modules is still high. Both STP and TSL have indicated actual demand for their products was double their capacity, and as a result both companies along with YGE have been more selective in allocating their capacity. By dealing with the most qualified downstream systems partners, tier one companies such as YGE could limit risk uncertainties on its annual shipment goals. While either higher cost or lower value added industry peers have been idling or shutting down capacity, many first tier Chinese companies have had to continually operate at full capacity to meet their annual targets.

Thus when Italian policy uncertainties placed projects on hold, shipment volumes dedicated to these projects had no choice but to also be placed on standby because such committed volumes could not be replaced if reallocated. As Trina Solar described, delay decisions made by project developers came at the "last hour" at the quarter's end. Even if Yingli wanted, there wasn't enough time left in the first quarter to halt production and thus reduce external cell procurement. Many tier one providers issued confidence once Italian policy was finalized, projects placed on hold would resume and thus required companies to continue operating at full utilization. As many first quarter earnings report came after Italian FIT were set in early May, pre-announced companies such as TSL and YGE stated delayed volumes would be shipped in the second quarter as reflected by strong sequential shipment growth forecasts.

In addition, Yingli's new capacity additions this year would not be available until the third quarter. Continued underutilization of new Panda lines would further result in external cell procurement at perhaps even greater magnitudes given the company's strong second quarter shipment guidance. This factor along with high single digit percentage ASP declines are among the key reasons for YGE's second quarter low to mid-twenties percentage gross margin guidance.

Since 600mw of the 700mw capacity expansion in 2011 is Panda based, continued slow ramp up cycles could further negatively impact gross margin in the second half. In order to meet Yingli's full year shipment guidance, the company would have to be running at full utilization of existing as well as new capacity additions expected to come online around mid-year. This would require newly installed Panda lines to become fully utilized almost immediately. Any production delays related to adjustments in this new technology would most likely cause continued cell procurement in the second half at similar ratios.

Luckily for Yingli, current market conditions within the industry are trending in its favor. First, the oversupply situation is more evident in the solar cell vertical. Based on management's comments made during the earnings call, spot market prices for solar cells have dropped to around .85/watt or down almost 30% from the 1.20/watt YGE most likely paid in the first quarter. Yingli's actual procurement price may be higher since as a top branded supplier itself, it would be unlikely the company can procure solar cells from anyone. Procuring solar cells from similarly bankable higher tier providers may have to be made at a premiums to current spot market prices. Nevertheless, the spread between current solar cell pricing and YGE's module ASP can still yield extremely generous gross margin in the mid to high teens percentage whereas less bankable lower value added module suppliers might only generate single digit gross margin under the same arrangements.

Second and more importantly, the spot market price for polysilicon has dropped significantly from over $80/kg just a month ago to under $60/kg recently as noted by Digitimes. During the first quarter, Yingli noted blended silicon costs continued to rise in the mid-single digit percentage. Again, while the company did not reveal actual figures, enough information has been disclosed to estimate its blended silicon cost were in the high $70s/kg for the first quarter. With indications of supply and demand slowly normalizing pricing across all verticals, YGE still has over .15/watt of unit cost savings just from polysilicon if prices return to levels around $50/kg seen a year ago. Per watt savings from polysilicon should more than compensate second half module ASP declines as currently forecasted by Yingli and other leading tier one suppliers. As a result gross margin should improve relative to the first half average.

In the near term however, Yingli should face margin pressure which may trough in the second quarter. Despite polysilicon prices already dropping significantly in the current quarter, there is roughly a quarter lag time before lower costs are realized in the company's earnings. Current lower cost procurement must be blended with existing higher cost inventory. YGE's absolute inventory level was also fairly high at the end of Q1, and as a result the company's blended inventory costs may decline slower than some peers. For example, at the end of the first quarter Yingli carried approximately a quarter worth of inventory based on current shipment guidance. In contrast, Trina Solar carried roughly a month worth of inventory for the same period relative to its second quarter shipment forecast.

The combination of slower blended inventory cost declines, high single digit module ASP declines, and continued external solar cell procurement should cause Yingli's second quarter gross margin to drop sequentially. YGE's second quarter guidance is extremely vague and open ended. As described, Yingli also expects current quarter's gross margin to drop to the low to mid-20s percentage from 27.3% recorded in the prior quarter. In terms of second quarter shipments, YGE expects sequential shipment growth of "at least 30%." This guidance should mark 400mw in Q2 shipments as the low end while leaving potential upside fairly open. However due to capacity constraints, it is unlikely the company can produce a significant shipment surprise for the current quarter. Below is an estimate for Yingli's second quarter 2011 earnings potential derived mostly from company statements.

YGE Q2 2011 Earnings Estimate:

Revenues: $620m
Shipments: 400mw
Asp: 1.55/watt
Unit Costs: 335 x 1.16 = $389m internal, 65 x 1.35 = $88m outsourced
Gross Profit: $143m
Gross Margin: 23.1%
Operating Expenses: $60m
Net Interest Expense: $20m
Tax: $9m
Minority Interest: $12m
Net Income: $42m
Share Count: 161m
EPS: .26

The earnings estimate above reflect only operational earnings and exclude non-operating items such as foreign exchange translations as well as unannounced gains or charges. As with all of my estimates made prior to the quarter's close, foreign exchange impact has been left out because with weeks of currency activity left in the quarter, it would be impossible to predict net foreign exchange translations. As of today's date, the key currencies in question, the euro, the usd, and the rmb, are relatively stable compared to exchange rates at the start of the quarter. As a result, net foreign exchange impact should be minimal. Assuming Yingli left currency and hedging exposure unchanged since the end of the first quarter, euro appreciation vs. the usd should generate net foreign exchange gains and vice versa while any rmb appreciation vs. the usd or the euro should generate losses to a smaller degree.

Lastly it is important to view Yingli's quarterly earnings in a larger context especially when longer trend dynamics counter balance short term influences. Many of the company's short term issues describe above should negatively impact second quarter gross margin, but these same factors could be reversed over the next several quarters. As a result, YGE's Q2 may be the company's trough margins for 2011.

Additionally, second half shipments have historically been 50% higher than first half levels. Yingli's reiteration of annual shipment forecast implies similar second half shipment growth over the first half. Stability of per watt gross margin at much higher shipment levels should dramatically improve the company's quarterly net income in the second half.

If YGE's annual shipment target is realized, second half net income should be equal if not greater than prior year levels. In short, Yingli's 2011 annual EPS should not decline vs. 2010 under the company's current guidance for the year. At roughly six times trailing earnings, much of the negativity regarding near term issues may already be priced into the company's share price.

Recent dynamics in the solar industry are slowly placing a greater divide between the winners and the losers. Many smaller scale, fragmented, and/or higher cost producers have recently reduced or shut down operations. Yingli like many first tier manufacturers is still expanding capacity and growing shipments while maintaining or growing profitability. The current bi-polar nature of the industry may cause an even greater shift in bankability that may drive increasing demand for the perceived winners within the industry..

Disclosure: I am long YGE, TSL, JKS.