While Suntech Power’s (STP) recent first quarter earnings missed Wall Street expectations at the headline level, there were also many strong points within the report. On a US GAAP basis, STP earned $31.9m, or 0.17 in fully diluted earnings per share (“EPS”). Analysts on average had expected Suntech to post 0.35 in first quarter EPS, which made it seem the company missed expectations by a wide margin. Excluding a $27m net foreign exchange loss and $6.5m of acquisition (Rietech) related amortization, or a combined negative impact of 0.18 in EPS, STP’s earnings on an operational basis would have been closer to Wall Street consensus at 0.35 in EPS.
To be sure, Suntech’s first quarter even on an operational basis was weaker than originally guided. Although only down about 3% sequentially, shipments were lower than the flat quarterly guidance given. Although up 280 basis points sequentially, gross margin at 19% was lower than the 20% expected. The combination of slightly lower shipments, slightly higher average selling price (“ASP”) degradation, and an unexpected uptick in processing cost, all contributed to a lower gross profit relative to my expectations. As a result, Suntech’s adjusted Q1 EPS at 0.35 missed my 0.48 estimates.
It is important to note that while Suntech’s results appear weak, relative to direct peers the company performed extremely well in the first quarter despite several unexpected negative factors that came into play late in the quarter. Unlike Trina Solar (TSL) and Yingli Green Energy (YGE), which both warned shipments would be approximately 10% lower than original expectations on Italian policy concerns, Suntech never re-adjusted its guidance.
As the industry leader in module shipment volume, that STP’s marginal 3% sequential shipment decline from a traditionally strong fourth quarter to a seasonally weak first quarter was impressive in itself. Weighted against the industry’s oversupplied state since the start of the year, Italian policy concerns in early March, and even a major catastrophic earthquake in Japan where the company generated 4% of its Q1 revenues prior to the event, Suntech’s first quarter resilience was even more impressive. After all, industry peers all noted the Italian market froze completely until feed-in-tariff (“FIT”) policy was finalized in early May. Suntech also noted in its earnings conference call business in Japan stopped completely following the country’s March 11 earthquake and tsunami.
Based on STP’s current shipment guidance, first half 2011 shipments should total approximately 1gw. Suntech’s annual shipment guidance remained unchanged at 2.2gw, which would place the company’s first half shipments at around 45% of full year targets. Historically, seasonally weaker first half shipment ratios were about 40%, or even lower, of annual shipments. Thus, the company’s shipments are already trending exceptionally strong despite headwinds already experienced by the industry. If historical trends apply for 2011, Suntech’s annual shipment guidance appears safe if not conservative -- although upside may be limited due to capacity constraints.
STP’s first quarter earnings report also highlighted the company’s strong silicon-based procurement. Suntech noted silicon wafer costs declined by 15% in the first quarter on a sequential basis when other industry producers and consumers of the product saw flat to only moderate declines in pricing. In addition, while blended virgin silicon costs rose from $55/kg to $60/kg in Q1 2011 over Q4 2010, it was still well below other US-listed Chinese solar company peers, which reported silicon costs ranging from the mid-$70s/kg to mid-$80s/kg.
Suntech’s stated contracted and spot market exposure for polysilicon implies contracted prices were below $50/kg in the first quarter. Additionally, management also stated in the company’s conference call that second half 2011 silicon costs should trend even lower, towards $45/kg. Once again, this statement implies STP’s contracted polysilicon pricing later this year is in the low $40s/kg. Known low-priced contracted silicon supplies -- combined with current spot market pricing declines -- should help stabilize if not improve the company’s gross margin later this year.
Processing costs for cells and modules increased unexpectedly for Suntech in the first quarter. Excluding share based compensation and shipping components, cell and module processing costs increased from 0.51/watt in Q4 2010 to 0.54/watt in Q1 2011. This increase alone impacted the company’s core module gross margin by roughly 1.8%. As noted by some peers, including Canadian Solar (CSIQ), higher silver paste caused solar cell processing costs to increase during the quarter. In addition, lower production days due to a shortened quarter and the Chinese Lunar New Year increased depreciation within non-silicon processing costs.
STP noted this trend would reverse moving forward. Direct peers have also indicated non-silicon material costs within overall module processing costs have declined since peaking in the past two quarters. Along with Suntech’s lower silicon cost procurement, a reversal of the first quarter’s high non-silicon processing cost trend in the coming quarters should help stabilize STP’s gross margin for the remainder of 2011.
In addition, Suntech’s internal wafer capacity is ramping well ahead of schedule. By the end of the first quarter, internal wafer capacity increased to 1gw, up from 600mw at the end of 2010, and ahead of the company’s prior 800mw target. Its full-year wafer capacity target remained unchanged at 1.2gw, although STP may achieve this targeted capacity well before the end of 2011. As a result, as much as 50% of second quarter module production could be using internally-produced wafers, which would further reduce blended unit cost. Higher ratios of internally-produced silicon wafers was the main contributing factor in Suntech’s 280 basis point gross margin improvement in the first quarter.
While lower silicon material component costs, improvements in processing costs, and higher levels of vertical integration will all contribute to a much lower blended module unit cost in the second quarter and for the rest of 2011, Q2 module ASPs are also expected to decline in the high single-digit percentage. Based on Suntech’s statements, unit cost improvements would barely be enough to negate falling ASPs in the second quarter. As a result, overall gross margin is expected to remain relatively constant compared to the first quarter. However, gross margin on a per watt basis should contract. Coupled with relatively flat sequential shipments, second quarter gross profit should decline slightly.
Suntech Power Q2 2011 Earnings Estimate:
Unit Costs: 250mw x $1.14/watt = $285m, 250mw x $1.30/watt = $325m
Core Module Gross Profit: $775m - ($285m + $325m = $610m) = $165m
Consolidated Gross Profit: $158m
Consolidated Gross Margin: 19.3%
Operating Expenses: $67m
Net Interest Expense: $31m
JV Minority Payout: $5m
Net Income: $43m
Diluted Share Count: 183m
As usual, the estimates above represent only operational earnings and exclude net foreign currency translations or other unannounced non-operational gains or losses. Suntech has had a notoriously bad track record in managing foreign exchange risks, as noted in my previous article. The company has reported a net foreign exchange loss in each of the past six quarters whether the impacting currencies, the euro and the USD, moved up or down in relation to each other. Had the company kept a constant hedging exposure instead of altering hedging practices every quarter based on market activity, much of the currency losses recorded last year would have been negated with gains.
For example, in Q4 2010, the euro declined vs. the USD slightly, which resulted in a small loss for Suntech. It also implied the company was slightly under hedged its euro-denominated exposure. Had STP kept that same, slightly under hedged euro exposure throughout Q1 of 2011, the company would have recorded a sizeable net foreign currency gain, as the euro appreciated over 5% vs. the USD in the first quarter. However, Suntech posted a net foreign exchange loss of $27m in the first quarter, suggesting at some point in the past quarter it changed its currency exposure again by over hedging euro-denominated assets.
The continued missteps regarding currency hedging not only caused STP to dedicate a page in its recent Analyst Day Presentation, but also introduced a new currency risk exposure page in its Q1 2011 earnings presentation. Net foreign exchange exposure represented in its earnings presentation indicate an unchanged over hedged position as witnessed in the first quarter. Based on the most recent euro vs. USD exchange rate, STP should post another foreign exchange loss around $10-15m for Q2 2011. However, since there is still another full month of currency trading left, it’s impossible to estimate the ultimate impact right now since the net foreign exchange translations will be based on where key currencies end the quarter relative to each other.
Suntech announced late last year it would form a joint venture with local groups to build 1.2gw of cell capacity, of which at least 600mw should be completed in 2011. This joint venture represents all of the company’s new cell capacity this year above its 1.8gw capacity at the end of 2010. As a result, some earnings dilution should take place for solar cells produced by this joint venture. It’s possible Q2 production will include cells produced by this joint venture, since STP announced 400mw of capacity was completed at the end of the first quarter. Since Suntech only owns 40% of this joint venture, it’s unlikely they company would consolidate operations into its earnings report.
Although it’s still not certain how STP will treat this joint venture from an accounting standpoint, the estimates above assume a minority payout separate from the company’s earnings. If instead consolidated, the payout would likely be represented as increased cost of revenues which would result in a minor gross margin dilution.
Lastly, the tax rate assumed is 20%, which is above a 15% tax rate Suntech could use if preferential high technology tax status is granted to one of its subsidiaries (Rietech). It is common for many companies in China to assume normal tax rates until preferential tax rates are granted or renewed, which may take several months. If granted or renewed, the lower tax rate would retroactively be applied to prior quarter(s).