Trina Solar: Profitability Pressures, But Long-Term Potential

Aug.25.11 | About: Trina Solar (TSL)

The second quarter of 2011 was not a good quarter for Trina Solar (TSL). In fact, the company posted its lowest quarterly net income in over two years since a $10.6m loss was recorded in the first quarter of 2009. Ironically, early 2009 was also the period when the industry experienced steep average selling price (“asp”) declines across all segments of the crystalline solar value chain. Since last May, the industry has also experienced dramatic asp declines across all major verticals, although far below the magnitudes seen in late 2008 and early 2009. Nevertheless, the pricing correction was sharp enough such that when coupled with procurement costs, lagging real time sales squeezed Trina Solar’s margins considerably.

Revenues in Q2 did rise sequentially from $550.1m to $579.5m despite dramatic module asp declines of 15%. A quarterly increase in shipments from 320MW to 397MW helped buffer part of the pricing pressure. As a result of asp declines, gross margin declined from 27.5% in Q1 to just 17% in Q2 and resulted in a significant sequential gross profit decline from $151.3m to $98.3m. With operating expenses already scaled to higher business volumes, US GAAP net income took the largest hit coming in at $11.8m vs. $47.7m reported in the prior quarter. On an earnings per share basis (“EPS“), Trina Solar earned 0.17 per share which were well short of Wall Street consensus of 0.47 in EPS.

TSL’s headline Q2 earnings miss was more the result of portions of the analyst community not fully reflecting the company’s earnings pre-announcement earlier this month. Trina’s earnings warning was detailed enough such that Wall Street EPS consensus of 0.47 was impossibly too unrealistic on the high side. In fact, the company actually surpassed my revised estimates which called for operational net income of $19m vs. the $22.6m TSL posted once a non-operational net foreign exchange loss of $10.8m was factored out. While Trina Solar’s currency loss was slightly higher than I had estimated, my US GAAP EPS estimate of 0.16-0.17 was a better reflection of the company’s actual 0.17 number than Wall Street’s 0.47 estimate. Investors may have also come to the same conclusion Trina did not miss its revised guidance since TSL shares rallied over 8% post earnings.

Still, Trina Solar took a huge credibility hit lately by having to revise earnings guidance for two consecutive quarters. This may be more damaging for TSL investors who had grown accustomed to conservative guidance and significant upside earnings surprises during the past two years. In Trina’s Q2 conference call, the company admitted on two occasions how it misguided forward looking margin and asp assumptions. Hopefully through this acknowledgement, forward guidance into the third quarter will be conservative enough for Trina to meet or exceed.

However, the change in pricing expectations from prior implied ranges is significant. In Trina Solar’s Q1 2011 earnings conference call, management expected module asp declines in the single digit percentages for the second quarter. Instead, a quarterly asp decline of 15% was reported. TSL also stated annual asp declines would not range lower than mid-teens percentage decline from Q1 levels, or the asp range the company actually reported in Q2. Yet, further asp declines are expected for the third and potentially the forth quarter as well. While shifts in market dynamics are not entirely Trina’s fault especially when industry leading direct peers Suntech Power (NYSE:STP), Yingli Green Energy (NYSE:YGE), and newcomer Jinko Solar (NYSE:JKS) all made the same mistakes in guidance, lower than previously expected asp ranges for the second half of 2011 will significantly alter all prior annual earnings estimates for these companies.

Statements I had made reflecting potential gross margin improvement in the second half of this year may still play out for Trina Solar. As conveyed in my prior articles, I believed the second quarter would mark a trough earnings quarter for leading names in the sector. Even despite lower targets detailed in TSL’s Q2 conference call, implied gross profit and thus net income would likely rise in the second half. At least in Trina’s case, Q2 could also mark the low point in the company’s gross margin. Granted the company’s second quarter trough may be at lower levels than previously expected, but it would still nevertheless be a trough quarter in terms of annual earnings. For companies with higher inventory turns, cycle troughs may be pushed out further than Q2 since the lag period between blending lower procurement prices with higher cost inventory would be greater.

While recent asp declines across all major verticals in the solar industry may cripple many less competitive peers, it is far from a death sentence for Trina Solar. Just in the past two weeks alone, Intel spin-off SpectraWatt and higher profile Evergreen Solar (ESLR) filed for chapter 11 bankruptcy. Even among some lower cost, albeit fragmented suppliers, in Taiwan have experienced order flow declines up to 85%. As peer Suntech described in its prior earnings conference call, lower tier producers have been shutting down uncompetitive capacity and liquidating inventory. In its Q2 conference call, Trina Solar also describe the recent pricing environment as less competitive peers selling at “non-sustainable reinvestment economics” in a bid to raise cash for survival. Until inventory of this nature has been fully absorbed by industry demand, spot market pricing trends will continue to reflect liquidation and consequently put pressure on more bankable higher tier brands such as Trina Solar.

In turn as TSL and other tier-1 peers drop prices, more and more of the industry already at the edge of corporate profitability will be pushed to the breaking point. Industry leaders such as TSL will face margin pressure, but as already evidenced can still maintain profitability. Short term margin pressure is a small price to pay for longer term competitive positioning as more and more weaker peers get forced out while Trina Solar gains market share. Without question, large scale US listed Chinese solar companies such as Trina Solar, Yingli Green Energy, and Suntech Power are all benefiting, as seen in the shipment volume increases reported by each company. Both Trina and Yingli achieved record Q2 shipment levels which rose by approximately 78% and 85% respectively on a year over year basis.

Global demand for photovoltaic (PV) solar products is still very strong and unlikely to decline from last year's record levels. Demand for high tier bankable solar products is also extremely robust as witnessed by the high shipment growths among leading manufacturers. However, demand for products at uncompetitive capacity thresholds has been extremely challenging this year.

Despite another potential low-teens percentage module asp decline in the third quarter, Trina Solar should still be able to keep gross margin stable. That is because its costs have not yet reached a near term low. Because the majority of the company’s polysilicon supply is contracted, pricing terms are subject to contract terms. As noted in TSL’s Q2 earnings report as well as its annual report, contracted pricing is variable but only adjusted periodically and not in real time relative to current spot market levels. As a result, while spot market polysilicon pricing dropped from over $80/kg to under $60/kg in May and June, TSL’s procurement costs may have been at higher levels set at the previous pricing adjustment date. In its latest earnings report, management did specifically indicate pricing has been renegotiated and third quarter cost levels would drop by the mid/high teens percentile. This factor, along with inventory turns, will determine how fast TSL as well as similar peers achieve realized cost levels more consistent with current real time market pricing. At cost levels normalized to current market pricing, Trina Solar should be able to maintain if not increase gross margins in the second half even despite additional projected module asp declines upwards of over 10%.

In addition to pricing pressures less competitive peers must also face, many large scale producers such as Trina Solar have been expanding their product mix. All three of the largest Chinese module producers -- TSL, YGE, and STP -- have been heavily investing in research and development. In the past, these efforts were minor and did not differentiate vs. other industry peers large or small. Recently however, many larger producers have expanded products to help further insure its ultimate consumption. Such efforts include but are not limited to the development of higher efficiency products, more specialized products from a visual or functional standpoint, and further downstream offerings such as standardized systems products to help reduce the overall balance of system costs. At an annual run rate of approximately $50m, Trina Solar is currently spending more on research and development than many solar industry peers make in an entire year. As a result, smaller or newer industry participants may find it harder and harder in the future to enter or maintain a competitive position as a fragmented single solution provider when larger scale peers can out spend rivals in offering total solution packages at potentially lower cost points due to scale.

While Trina Solar’s competitiveness within the industry may be improving, in the near term, for reasons detailed above, its earnings will experience higher profitability pressure than in the recent past. As usual, based on TSL’s own guidance ranges as well as other implied metrics without speculation beyond these parameters, earnings for Trina’s third quarter are provided below.

Trina Solar Q3 Earnings Estimate:

Revenues: $640m
Shipments: 500MW
ASPs: $1.28/watt
Blended Unit Costs: $1.06/watt
Gross Profit: 500 x .22 = $110m
Gross Margin: $110m / $640 = 17.2%
Operating Costs: $68m
Net Interest Expense: $7m
Tax: $7m
Net Income: $28m
Diluted Share Count: 79m
EPS: 0.35

1) Potential Preferential Tax Status Reversal Gain: $6m
2) Potential Net Currency Gain: $3m
3) Potential Convertible Bond Dilution Benefit: 10% EPS Accretion

As with all my estimates, only operational earnings are factored while unannounced non-operational gains or losses have been excluded. In addition, there may be three major items that have not been officially guided by may ultimately affect US GAAP results.

The first is a tax status reversal from the 20% paid in the first half of 2011 to a 15% rate which would apply once Trina Solar’s main subsidiaries are formally granted high technology preferential tax status. The overpaid taxes would be retroactively applied to the quarter and thus lower the effective tax rate.

Secondly, some form of currency translation should take place as long as the euro and usd exchange rate differs from the 1.45 level ending Q2. A number lower than this benchmark should produce net foreign exchange gains for TSL and vice versa. Based on today’s exchange rates, Trina Solar would record a net currency gain of $3m.

Finally, Trina Solar’s share prices has recently fallen below the conversion strike price of its 2008 issued convertible bonds. As long as its share price remains below $17, dilution effects from the convertible bonds may not be factored into the company’s fully diluted share count. The effects may be factored over daily closes and thus affect the weighted average diluted share count. If for example TSL remained below this conversion strike price for the entire third quarter, the roughly 10% dilution would not be realized and thus the diluted share count would be 8m lower than the 79m referenced above.

Disclosure: I am long TSL, YGE, JKS.

Additional disclosure: No Position in STP, ESLR.