By the time Renesola (NYSE:SOL) reported its second quarter 2011 earnings on August 9, many investors had already been bracing for the worst. Steep drops in average selling prices (“asp”) for solar products since early May caught many companies by surprised and many U.S. listed Chinese solar companies ultimately warned on lower than expected second quarter results. I had projected SOL’s Q2 earnings to be lower than the company originally guided but even my lowered expectations were too optimistic. A month after my cautionary article, Renesola officially lowered its earnings expectations for the second quarter.
With much of the results already anticipated, Renesola’s actual earnings report was a bit anti-climatic. Despite a U.S. GAAP headline miss with 0.02 in earnings per share (“EPS”) vs. Wall Street expectations of 0.16 in EPS, SOL’s shares rallied over 14% after its earnings announcement. Perhaps company shares had already factored in much of recent negativity as its stock price had already lost two thirds in value since the start of 2011. In fact within the past day, Renesola’s board not only recently adopted a poison pill but also announced a $100m share repurchase plan which if carried out in full at current prices could eliminate over half the share float not owned by insiders.
After all, despite a probable large decline in annual earnings this year, Renesola’s near term operations may only be straddling the breakeven point at the corporate level. While that may not sound interesting, the company is generally outperforming much of the solar industry on a relative basis. Many smaller scale, less integrated, or higher cost producers have seen large declines in business. Less competitive producers have curtailed production and liquidated inventory in order to generate cash flow for survival purposes. While not a major surprise within the industry, formerly high profile Evergreen Solar (ESLR) filed for chapter 11 bankruptcy last week.
Renesola’s second quarter may have hit the breaks in dramatic form, but the company did not crash into a wall either. Revenues declined sharply by 30.6% on a sequential basis to $249.3m due to lower shipments and selling prices. Gross profit declined by over 50% sequentially to $45.9m. To the company’s credit, operating expenses were reduced by roughly 10% from Q1 levels. While net income missed analyst expectations by 0.14 in EPS, SOL’s operational results actually exceeded my revised expetcations of $9m in operational earnings which excluded non-operational items. Excluding net foreign exchange losses of $8.3m and an impairment loss of $2.7m, Renesola’s operational earnings were $12.8m, or 0.15 per share.
However, earnings should not improve in the third quarter based on Renesola’s guidance of revenues between $220-240m with gross margin ranging 6-8%. Just using a simplistic mid-point calculation, the company should generate only $16.1m in Q3 gross profit. That would almost represent a two thirds decline in quarterly gross profits and would not even cover the operation expense level seen in the second quarter. After interest expenses, SOL would likely record a net loss for Q3.
While Renesola is likely to post a net loss for the third quarter, it is more a reflection of the company absorbing the industry’s recent asp correction than an indication of its competitiveness. Anytime the solar industry experiences sudden and sharp asp declines, companies normally have to blend existing higher cost inventory with new lower cost procurement price levels. Until a company’s cost levels are in line with current market levels, reported earnings have not been normalized. In some cases, inventory provisions are taken in order to achieve normalized earnings more quickly than the typical 2-3 quarter lag experienced in past cycles.
Although this factor is in part true for Renesola, it’s not the main reason for the company returning to a more normal earnings level. Renesola’s main material procurement is polysilicon which currently ranges between $50-55/kg on the spot market. However, the company reported a blended polysilicon cost of just $54/kg in the second quarter mainly due to a healthy 787 metric tons of internal quarterly production at a reasonable below market cost of $42/kg. With internal production costs expected to decline slightly in the third quarter, overall polysilicon blended costs may only decline marginally to the high $40s/kg. In other words, Renesola would require additional cost savings to offset the expected 20% sequential silicon wafer asp decline in the third quarter.
Part of its strategy comes from horizontal integration. In the past the company procured consumable products used in its silicon wafer production externally. With planned steel wire production as well as increased slurry recovery capacity, Renesola hopes to reduce wafer processing costs from Q2’s 0.26/watt to 0.19/watt by the end of the year. This processing cost reduction in combination with a lower blended silicon usage cost should ultimately generate enough gross profit for the company to return to corporate profitability even at a potentially conservative forward looking silicon wafer asp assumption.
While SOL’s management should be given credit for correctly predicting solar module asps could drop to as low as 1.10-1.20/watt, its overall argument on industry pricing remains flawed. Spot market prices have already penetrated this range, and U.S. listed Jinko Solar (NYSE:JKS) which originally dismissed SOL’s prediction as too low recently admitted its own module asps could reach or even fall below 1.20/watt in the second half of this year. That was only half of SOL’s argument. The other half insisted its own silicon wafer asps could hold 0.70/watt even if such pricing would cause clients to potentially lose money purchasing and consuming its wafers. With SOL’s wafer asps already reaching 0.69/watt in Q2 and are expected to drop further to 0.55/watt in Q3, Renesola’s thesis has already broken.
Yet management continues to make industry predictions which contradict supply and demand dynamics experienced within the industry. In short, no single segment within the industry’s value chain can enjoy disproportionate profits or losses for an extended period of time. In the short term supply and demand dynamics can and have altered the profitability profiles of solar companies operating in different segments of the value chain but these imbalances have often been quickly resolved. Thus it would be a wrong to assume any company could maintain high levels of profitability at the expense of its upstream or downstream partners for any extended duration.
Much of the industry’s recent pricing trends have been explained by other leading peers as inventory liquidation from less competitive producers as explained in Suntech Power’s (NYSE:STP) Q1 earnings conference call and JA Solar’s (NASDAQ:JASO) Q2 earnings conference call. With inventory levels still high from last year’s industry boom combined with first half 2011’s numerous demand shocks, solar asps across most verticals came under heavy pressure and were sold at levels where even the most cost effective producers could not make money. As one analyst questioned in SOL’s Q2 conference call, if Renesola considers itself as a low cost leader but cannot make money at current pricing levels, wouldn’t this pricing environment be unsustainable? The industry will only know after inventory liquidation has completely been absorbed by global demand. Just as Renesola painted a too bullish picture last year during the industry’s demand boom, it may be making the same mistake by over extrapolating recent negative pricing trends in the industry’s recent over supply period.
Perhaps part of Renesola’s caution may be linked to its own competitive positioning within the industry. Unlike larger and more integrated peers such as Trina Solar (NYSE:TSL), Yingli Green Energy (NYSE:YGE), and Suntech Power, SOL positioned itself as an upstream silicon wafer provider with concentration in polysilicon and wafer production. As previously explained, not only are silicon wafers a more commoditized product than downstream solar cells or modules with less differentiation, but SOL leaves itself more vulnerable to demand fluctuations since it relies on customer’s ability to place products into the market. Renesola’s Q2 10.6% sequential shipment volume decline contrast sharply with quarterly shipment increases by more integrated solar module peers. SOL contributes part of Q2’s shipment weakness due to some capacity loss related to equipment upgrades but this factor would not make up for the gap in shipment direction between Renesola and integrated downstream peers.
While Renesola has provided a broad revenue and gross margin range for the third quarter, I have as usual compiled more detailed estimates based on metrics provided by the company. These estimates generally fall within the ranges guided by SOL and do not speculate outside statements directly made by the company. In addition as always, the estimates below represent only operational earnings and exclude any unannounced gains or charges which may be non-operational in nature such as net foreign exchange translations. A net foreign exchange estimate is provided separately based on current exchange rates as of today’s date and assume currency and hedging exposure constant with the prior quarter. Since a net loss is expected, the tax is assumed to be nil although a small tax benefits could be reported.
Renesola Q3 Earnings Estimate:
Wafer Shipments: 200mw at .55/watt = $110m
Module Shipments: 90mw at 1.20/watt = $108m
Wafer Tolling: 50mw at .30/watt = $15m
Poly Scrap: $10m
Total Shipments: 340mw
Wafer: 200mw at .51/watt = $102m
Module: 60mw at 1.05/watt = $63m, 30mw @ 1.15/watt = $34.5m
Wafer Tolling: 50mw at .25/watt = $12.5m
Poly Scrap: $10m
Total COGS: $222m
Gross Profit: $21m
Gross Margin: 8.6%
Operating Expenses: $22m
Net Interest Expense: $7.5m
Net Income: -$8.5m
Diluted Share Count: 87m
Potential Foreign Exchange Gain: $2m
Potential Foreign Exchange EPS Impact: .02
While Renesola’s Q3 earnings may lag peers, this estimate is also not a true representation of the company’s earnings power once key metrics normalize to current market conditions as explained above. SOL expects Q4 gross margin to increase slightly to around 10%, but that also may not be enough for the company to generate an overall net income. Until the company’s silicon wafer processing cost reductions are fully realized and until its second phase polysilicon plant is fully operational at intended cost parameters next year, SOL’s profitability may continue to experience pressure as primarily a wafer supplier.
The company does have limited solar cell and module capacity. If demand returns such that SOL can fully utilize these segments of its capacity, incremental gross profits could help the company achieve corporate profitability sooner. Renesola could still alter its strategic course by further integrating downstream by increasing its cell and module capacity. This would not only provide incremental profits on top of its wafer segment, but give the company more control in placing its overall capacity in the industry. However, statements made in the company’s most recent earnings and conference call suggests SOL is still dedicated to being a low cost wafer supplier. While this strategy can still be successful especially if Renesola achieves cost targets set for next year, being a fragmented supplier in an industry increasingly integrating to cut costs could leave SOL more vulnerable to short term supply and demand imbalances such as ones recently experienced.
Disclosure: I am long TSL, YGE, JKS. No position in SOL, STP, JASO, ESLR.