Earlier this week China Synergy (CSUN) warned second quarter earnings would fall short of prior guidance given in its first quarter earnings report. Despite the warning, CSUN’s actual results should be of less importance if it becomes a trough quarter for the company this year. The more important aspect of China Sunergy’s warning is how it helps evaluate the company’s competitive positioning within the solar industry moving forward. With the company already making a big expansion gamble, 2011 could be a critical year in determining in which side of a potentially bi-polar and destructive environment CSUN resides.
At face value, China Sunergy’s warning appears dire. Not only are shipments expected to fall 20% below prior guidance to 100-110mw, but gross margin is also expected to drop to just 1% from the prior 7.5-8.5% range. CSUN also revised 2011 shipment guidance to 580-600mw from 670-690mw. The company blamed slower digestion of higher cost inventory, higher procurement costs for consumables such as silver paste, and lower than expected average selling prices (“ASP”) for solar modules as the main reasons for its lower margin guidance. Unexpected delays in project financing was blamed for its lower shipment guidance.
While lower than expected shipments would result in a slower rate of reduction in blended inventory costs, the effect should be minimal since China Sunergy only guided module shipments down by 20mw. In addition, the company’s second explanation of higher component costs such as silver paste seems to contrast with what some peers have noted in recent conference calls. Many China-based module-producing peers noted component costs were in a general downtrend from first quarter peaks. While procurement cost increases may be more company-specific to CSUN, its overall impact should also be minimal, given the trends peers have indicated.
Perhaps the main reason for China Sungery’s lower gross margin guidance is related to lower module ASPs. Although the company reported Q1 earnings in late May after most of the pricing declines across all verticals had already been realized, CSUN still gave a rather aggressive module ASP guidance for Q2. For the second quarter, it guided module pricing to range between 1.55-1.65/watt -- well above spot market rates of approximately 1.40/watt, as tracked by PVInsights. Sunergy’s new guidance implies module ASPs in the mid- to high-1.40s/watt range.
The most important takeaway regarding CSUN’s lower module shipments at even lower than expected ASPs is that the company overestimated its sales channel strength. During last year’s industry boom, any producer even new brands were able to place its modules in an under supplied market. Now with the industry in an over supplied state, less competitively positioned producers have resorted to dramatic price cuts in order to place products. In situations where lower pricing generates higher levels of shipments, there is less of a concern. But if lower pricing does not generate higher volumes, then it could be a warning signal the company’s competitive position isn’t very strong relative to peers.
Industry demand normally flows through the highest tier companies first and moves down to lower tier companies. While China Sunergy’s current guidance is far from the fate of many smaller or fragmented industry participants which in some cases revenues have dropped over 50% so far in the second quarter relative to the first quarter, its recent warning may indicate the company is positioned near the borderline of the demand curve. Most of CSUN’s capacity is bankable enough to be encompassed by the current demand curve, but not strong enough such that the company is fully booked like China’s big three tier one brands Suntech Power (STP), Trina Solar (TSL), and Yingli Green Energy (YGE). If overall industry demand does not continue to track as expected by the sector, CSUN’s forward shipments may be more in jeopardy than higher tier rivals.
China Sunergy’s higher uncertainty over meeting shipment targets was why I viewed its recent expansion strategy as a huge gambit. With an already weakening balance sheet, CSUN’s financial ratios could become worse if shipments do not grow in accordance to its aggressive capital expansion plans this year. The gamble is amplified given the company’s average bankability profile which puts its shipment targets more at risk relative to higher tier peers. Even despite the recent downward annual shipment revision, China Sunergy still expects second half 2011 shipments to double levels experienced in the first half. The company already suffers from execution issues over the past few years as a public company such that its current guidance still represents significant risk.
The other side of recent module ASP declines witnessed since the start of 2011 is that upstream component ASPs have also declined equally if not to a greater degree. As a result, when module suppliers report earnings which reflect both current module as well as procurement ASPs, gross margin should expand from second quarter levels. Leading tier suppliers such as TSL, STP, and YGE, just like CSUN, are all experiencing lag periods in fully digesting higher cost inventory which may take up to a couple quarters before procurement costs as well as selling prices fully normalize with each other.
The faster China Sunergy can grow shipments, the faster it will be able to blend its inventory costs towards current procurement costs. If the company can achieve its implied second half shipment targets, then operating metrics should fully normalize somewhere in the middle of the second half. Once at this point, and assuming metrics currently witnessed in the markets as well as forecasted by industry peers do not change, CSUN’s gross margin should expand to at least 10% and up to the low teens percentage. While not spectacular relative to larger and more integrated peers, the reversal from margin contraction witness in the past several quarters to an expansion in the second half from the estimate 1% range in the second quarter would be enough to generate a positive net income for China Sunergy.
For the second quarter however, 1% gross margin will generate a net loss for the company. As a result, I have to revise my prior estimates accordingly. Due to lower than previously forecasted shipments as well as lower implied module ASPs, I now estimate CSUN’s Q2 2011 revenues to fall to approximately $151m. Net loss should total roughly $12m, or a 0.30 loss in earnings per share (“EPS”). Cost components in my prior estimate should only increase slightly by about 0.01-0.02/watt. As usual, this estimate assumes operational earnings only and exclude any unannounced gains or charges or other non-operating items such as net foreign exchange translations.
While execution risk is still high with China Sunergy especially considering the company’s past performance in managing industry cycles, much of this uncertainty may already be reflected in the company’s share price. At current valuations, CSUN’s market cap is only slightly above $70m. While evaluating any solar company vs. asset value isn’t an ideal gauge, China Sunergy still generated nearly $52m in net income last year. Even after recent changes in the environment for the solar industry and even after the company’s warning for Q2 2011, CSUN could still achieve the same level of profitability in the second half of this year compared to the second half of last year if its current annual shipment targets are met. Of course that is a big “if” when dealing with China Sunergy since the company is already at the borderline where solar industry winners and losers have already started to separate.
In summary, China Sunergy is ever increasingly becoming an extremely high risk but equally potentially high reward play among US listed Chinese solar companies. Judged separately, it may be a very interesting proposition for speculation. However given the entire solar sector has witnessed similar negative sentiment and thus severe multiple contraction, CSUN may be an unnecessary gamble given some peers are equally discounted while conveying much less risk uncertainty.