Old Mistakes Haunt Suntech's Q2 Earnings

Oct.28.11 | About: Suntech Power (STP)

By now, investors in Suntech Power (NYSE:STP) must be screaming “uncle!” Suntech’s second-quarter 2011 results included yet another legacy write-down when many investors thought the company had already cleaned the slate of past blunders. In the second quarter of last year, Suntech wrote down over $180M of bad investments. This year the company wrote off $225.7M mostly linked to a long-term supply agreement with MEMC Materials (WFR) originally signed in 2006. Additionally, STP also wrote down $30M of inventory as average selling prices in the crystalline segment of the photovoltaic industry collapsed since early May. In total, these charges caused Suntech to report a net loss of $259.5M for the second quarter of 2011.

Operationally, Suntech’s Q2 2011 was not as dire as the headline loss suggested. The company’s core product, crystalline solar modules, saw shipments rise 2% sequentially to an estimated 503MW. Although STP’s module shipments did not rise by the same quarterly magnitude as closest rivals Trina Solar (NYSE:TSL) and Yingli Green Energy (NYSE:YGE), the company still maintained the top market share position in the second quarter. As indicated in my recent articles on Trina and Yingli, it is important to realize large-scale branded module suppliers like Suntech were able to maintain high levels of shipments when smaller and more fragmented peers witnessed declining volumes.

Despite slightly higher shipments, continued asp declines caused revenues to drop from $877m in Q1 to $830.7m in Q2. Price declines also compressed the company’s margin from 19% to 4.1% sequentially. Excluding a $91.9M MEMC charge as well as a $30M inventory provision, adjusted gross margin only declined marginally to 18.7% which was relatively inline with STP’s prior guidance of flat gross margin and slightly below my gross margin estimate of 19.3%. Suntech’s adjusted Q2 gross profit of $155.6m was only slightly under my $158M estimate although down quarter over quarter from the $182.7M reported in the first quarter.

While operating costs (excluding MEMC settlement charge of $120M) were slightly higher than expected, Suntech once again continued its streak of net foreign exchange losses which tainted its US GAAP results. As described in a prior STP review, the company’s hedging losses had become so bad it devoted a section describing what went wrong. Whether key currencies appreciated or depreciated, Suntech found a way to lose money on its net currency exposure. In Q2 2011, STP reported another large net foreign exchange loss of $29.7M bringing first half 2011 currency losses to $56.2M.

As a result of these charges, Suntech reported a net loss of $259.5M in the second quarter. The company provided a non-GAAP loss of $33.8M or 0.19 per share which excluded $211.9M in MEMC charges and $13.8M for a write down of CSG Solar. Wall Street’s average analyst consensus was for a profit of 0.15 in earnings per share. Excluding the $30M inventory provision and the $29.7M in net foreign exchange loss which my estimates did not include, Suntech’s operational earnings for the second quarter was $26.2M or 0.14 EPS vs. my $43M or 0.24 EPS estimate. The difference was mainly attributed to $17M in higher than expected operating costs.

For the third quarter, Suntech’s official guidance is for a 15% increase in quarterly shipments and gross margin between 11-13%. The company also noted in its Q2 2011 earnings conference call module asps in the third quarter may drop in the mid/high teens percentage. While the $30M inventory provision taken in the second quarter helped reduce inventory carrying costs for the third quarter, higher magnitudes of expected asp declines should further compress the company’s per-watt gross profit.

As usual, I have compiled a third-quarter earnings estimate for Suntech based on the company’s guidance as well as direct and indirect comments made by the company during its earnings conference call. Again as usual, these estimates are within metrics given by the company and do not speculate beyond company statements.

Since the third quarter has already closed, currency exchange rates for key currencies in question are already known. Thus a net foreign exchange estimate has also been included in this estimate based on STP’s stated currency and hedging exposure in its Q2 2011 earnings presentation. Outside of this foreign exchange translation estimate, all other non-operational unannounced gains or charges have been excluded in this estimate. Given Suntech’s horrid track record of earnings charges related to bad legacy investments, investors will still have to cross their fingers on each of the company’s earnings releases.

Suntech Power Q3 2011 Earnings Estimate

Revenues: $795M

Shipments: 578MW

Asps: $1.29/watt

Unit Costs: 1.13/watt

Core Module Gross Profit: 578MW x .16/watt = $92.5M

Systems/Other Dilution: $7M

Consolidated Gross Profit: $85.5M

Consolidated Gross Margin: 10.8%

Operating Expenses: $86M

Net Interest Expense: $33M

Net Foreign Exchange Loss: 2.5M

Net Income: -$36M

Diluted Share Count: 180M

EPS: -0.20

While Suntech should report an operational loss for the third quarter, its operational metrics still have room for improvement. STP’s high inventory level of $571.4M ending the second quarter will result in lower inventory turns. As a result and similar to many peers like Yingli, it will take Suntech longer to blend its inventory carrying costs down to current procurement levels. While solar module asps are still likely to decline from Q3 levels, unit production costs based on current spot market pricing should decline at a higher magnitude once at normalized levels. Suntech’s estimated 0.16/watt module gross margin in the third quarter is likely to be near or at trough levels.

Suntech’s history of sour investments has taken a toll on the company’s balance sheet. As one of the earliest and largest industry manufacturers, Suntech has been able to secure extremely high levels of capital relative to many other US listed Chinese peers. Many peers such as Trina Solar have only raised capital through Wall Street in the range of $100M-150M at a given time. In contrast, with two separate convertible bond issuances in 2007 and 2008, Suntech was able to raise over a billion dollars. Access to excess capital in the early Wild West years of the solar industry’s growth period resulted in a number of investments which were not core to Suntech’s business.

Instead of simply expanding or further integrating its capacity, Suntech made a series of strategic equity investments which since the start of 2010 alone resulted in over $400M of write-downs. Combined with currency hedging blunders, STP lost an additional $150M in the same six-quarter period. Suntech which once had one of the strongest balance sheet among peers reported total debt levels over $2.4B vs. cash levels just under $770M ending Q2 2011. The company’s working capital deficit also expanded further to around $213M during the second quarter.

While it’s likely as the largest solar module manufacturer in the world Suntech can continually revolve its current debt with local credit facilities, interest payments have become a material impact on the company’s bottom line. Quarterly interest expense which were below $10M a couple years ago have increased to $32.5M in the second quarter. Combined with the company’s current operating expense run rate, Suntech would require per watt gross profit levels for its core solar modules to range around 0.20/watt just to break even at the US GAAP level. While this is achievable at normalized metrics under the current pricing trends, asp declines since May have been severe enough such that the industry’s largest producer would struggle to stay profitable.

Most likely after less capitalized companies enter insolvency and after the resulting inventory liquidations abate, pricing trends should revert back to levels more indicative of the present demand curve. Demand for solar modules has always been strong. Although many observers often cite a lack of demand that caused asps across all crystalline verticals to drop, statements such as these can be deceiving. In fact global demand this year is expected to be higher than the record levels of 2010. Over expansion by many participants that really had no business expanding caused a major supply overhang in the industry.

As pricing declines snowballed below the production cost levels of many manufacturers, liquidations escalated and brought pricing levels to the point most companies cannot make money. At the current pricing spreads between major crystalline verticals, perhaps as much as two thirds of cumulative installed capacity has been rendered obsolete. Using history as recent as 2009 as a guide, less competitive companies will eventually shut down and pricing should start to stabilize. A key difference from the down cycle a couple years ago is that current pricing would only support a few dozen companies instead of a few hundred. Ultimately the industry may consolidate until only one or two dozen low cost and large scale manufacturers remained.

As the largest supplier and a reasonably cost effective producer, Suntech’s operating metrics should be strong enough to validate it as a survivor. Clearly the current stressed pricing environment is not favorable for any company within the industry and Suntech will likely continue to struggle to stay profitable until pricing normalizes. As long as the company can avoid costly capital allocation mistakes it has made in the past from repeating, STP should continue to gain market share from companies exiting the field. If cost cutting initiatives Suntech has cited in prior earnings conference calls start to materialize, modest profitability could return sooner. In summary, Suntech has what it takes to succeed in the industry on paper, but as I noted in prior STP articles investors should consider discounting the ability of its management team to execute its business successfully and not squander what’s left of the company’s still dominate position within the solar industry.

Disclosure: I am long YGE, TSL. I have no position in STP, WFR.