The solar industry displays a number of curious characteristics that, on the surface, are hard to explain. Here are a few:
- The extremely low valuation (price-earnings multiples in the low single digits), despite often near triple digit growth.
Companies being 5-10x bigger than four-five years ago but hardly more valuable.
The seemingly insane race to expand capacity while there is an increasing market glut and solar panels are basically a commodity.
This is the industry of the future, right? In a way it is, because it's about the only energy source that is getting cheaper. In the 1980s, a solar module cost in the order of $25 per watt. Today, these costs have dwindled to a fraction (less than $1 per watt for some producers) and there is no a-priori reason to believe that the march of innovation and efficiency gains will come to a sudden halt.
While the time that solar can compete with other sources is still quite a while off (and the intermittent nature of the energy source is an additional considerable complication), a path towards that is at least feasible. By expanding capacity, the industry reaps economies of scale and learning, while the steady pace of innovation leads to a stream of new approaches that will bring costs down and increase efficiencies further.
But we're not there yet, not quite. In the meantime, the industry depends quite heavily on subsidies. And with these subsidies lately less exuberant in the two most important markets (Germany and Italy), there is suddenly a host of excess capacity. As a result, prices are plunging. At the end of 2010, average selling prices (ASP) were $1.82 per watt (at least for Trina Solar (TSL)). Now they're plunging towards the $1.20 range. Quite a steep fall.
Lower prices eat into margins, hence the dramatic fall of the stocks. And this despite the fact that most of these companies are several times bigger than 3-4 years ago. But isn't this fall overdone? After all, falling prices have a tendency to clear the market and the industry is rather cyclical. So surely an upturn will occur at a certain point in time?
Well, one explanation for the dramatic swings is simply that financial markets have a tendency to 'overshoot', a term coined by the late Rudy Dornbush in explaining this phenomenon for the currency markets.
But there could be something else at work here. One curious thing is that in the face of a rather large glut, companies are not dramatically cutting back on plans to build more capacity. That's odd, because the balance sheets of quite a number of these companies are not in terrific shape.
We would say that logic has it that in the face of a glut, cutting back on capacity expansion serves the dual purpose of preserving capital and keeping prices higher. There could be a bit of a fallacy of composition, as this is a logic that applies to all players together, while not necessarily for each individual one.
It could be that, by aggressively expanding capacity, the strong players (or those that perceive themselves as such) want to drive weaker competitors into the ground. This is Asia, after all, where market share often matters more than profitability as companies take a longer-term view.
However, there is another possible explanation, much less benign.
Enter John Hempton
In an extremely long blog post, John Hempton of Bronte Capital argues, with reference to Trina Solar, that it is forced to expand capacity, or die. He expects the latter to happen within seven months and "probably a lot sooner". Oops. Trina offers an interesting case because it's currently the low cost leader in the crystalline silicon (c-si) part of the industry, which is by far the largest part.
He noted that Trina has lots of cash ($750 million) at year-end (2010), but is still heavily drawing on short-term debt ($159M) and longer term visits to the capital markets. That happened twice in the last three years, issuing 10 million (adjusted for splits) and 9 million shares in August 2009 and March 2010, respectively, for a combined $320 million.
It also has $1.741B in short-term facilities with 'various banks' of which $651M are drawn. The latter doesn't appear anywhere on the balance sheet. Perhaps that's why analysts from Jeffries state that Trina's financial health is "solid". However, these facilities do explain the large cash position, leading Hempton to conclude:
And now we have a perfectly reasonable explanation of why there is more than three quarters of a billion dollars in cash on the balance sheet and the company is repeatedly selling equity to raise cash and rolling over lots of short term debt. They have a really big obligation which is "short-term" and relies on the banks to renew their facility. And the obligation is not on the balance sheet.
Why does the company embark on this kind of curious financial operations? They have purchase obligations for raw materials and equipment.
As of December 31, 2010, the Company had entered into certain long-term silicon procurement contracts, under which the Company agreed to purchase silicon materials in an aggregate amount of approximately $14.6 billion over the next four to seven years.
Needless to say, that is rather massive: $14.6 billion over the next four to seven years. Hempton goes on to make his case for a likely death spiral in the company. Demand is faltering, but the company can only survive by ramping up production ever faster. But since there is a glut and prices are falling, this results in all kinds of distress signals, like:
rising inventories (from $79M to $180M in a single quarter, Q1)
and sales (in dollars) that fall behind shipments (in MW)
and a rise in accounts receivable (from $571M to 664M in Q1 2011)
and negative cash-flow ($120M in Q1) which Hempton argues is understated, as these figures came from an exchange with an analyst at the Q1 earnings conference.
Leading Hempton to conclude:
This company has "profits" but negative cash flow because (in accordance with accounting standards) it counts increased receivables and increased inventory as part of its profits.
The lynchpin, the poly-contracts
However, we think the nature of these obligations is sufficiently vague as to be a little careful drawing too strong conclusions, perhaps. A number of questions bubble up automatically in our minds:
What is the exact obligation of these contracts? "Over the next four to seven years" suggests that these have a degree of malleability.
Are these all in fixed price, and if not, to what degree are these open for negotiation?
When did the company engage in these contracts and why (as Hempton argues that these will likely bring the company down, one could argue that these were spectacularly stupid).
To what extent do other solars have similar death-knell purchase contracts which forces them to produce (or, rather, sell) or die? If so, the fallacy of composition is complete and much of the industry will.
Chinese banks do at times operate as a 'soft-capital constraint', especially for those clients which are connected or are deemed of strategic importance.
On the nature of these contracts, this is what Hempton came up with:
And this contract is not easy to renegotiate because the polysilicon makers hold the bank lines, which is the equivalent of holding the cash. If Trina tries to get out of the contract then the polysilicon maker just draws the bank line and gets paid anyway. And Trina will wind up owing the money to the bank...[Hempton]
The main polysilicon contract is attached to the 2009 annual report. This contract specifies the way in which polysilicon prices in the contractare to drop if the spot price for polysilicon drops. In other words they are obligated to buy lots and lots of polysilicon - they are just not obligated to buy it at the current price. The contractual terms of their lending agreements require that they do actually process the polysilicon.
His conclusions are somewhat curious. While the requirement to actually process the polysilicon could explain the dash for capacity in adverse market circumstances, price is clearly variable within the contracts. That's something to keep in mind, as Hempton himself argues that what has gotten solar energy so cheap recently is mostly the 80% fall in... polysilicon prices:
But the real cost drops have been driven by polysilicon which peaked at over $400 per kilogram and is down by at least 80 percent.
So, the biggest driver of growth is now turning against the industry? And that at a time when polysilicon prices are at more or less rock-bottom, not far from marginal production cost?
An even much bigger question would be, why would companies engage in these kind of massive obligations if it is putting the existence of even the best (Trina is the cost leader) at risk- even the cost leader is at risk and even in conditions where the price of these obligations is at the far lower end of the spectrum?
It seems very odd indeed to bet the future of the company on polysilicon contracts when even the lowest of these polysilicon prices would oblige them on a do-or-die expansion path. Yet this is exactly what Hempton implies. For Trina this would be doubly ironic as the company's revival came to a considerable degree when it (unlike LDK Solar (LDK)) blew off plans to embark on their own polysilicon plant.
Alas, we couldn't find anything on any of this in other solars. But if long-term polysilicon contracts are a death knell to the cost leader that, according to Jeffries, has a healthy balance sheet, then if others had engaged in similar contracts, none of them would fare any better, to say the least.
Chinese 'soft' financial constraints?
On the possibly 'soft' financial constraints of Chinese banks, Jeffries had this to say
Further, government-sponsored Chinese banks have shown a clear willingness to subsidize the growth of domestic solar companies. Though we expect lenders will be much less generous going forward, we think China's banks are still going to concentrate financial support on companies they feel will be the industry's long-term winners.
Would Trina, and perhaps other solars, embark on what would otherwise be reckless expansion in the expectation (or perhaps even tacit understanding) that they would be backed?
Another thing could be that they might know stuff about where the Chinese domestic market for solar energy is heading that we don't.
It could also be that Hempton is simply talking his book in a little too enthusiastic manner. It happens. While the picture he paints is very scary, his conclusions are by no means firm if we do not know the exact nature and understandings that rule the different parties in the Chinese solar sector.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.