By Stephen Simko, CFA
Solar companies' share prices have collapsed during 2011, largely because of two major factors. First, solar industry fundamentals have been deteriorating and are now as weak as they've been in years. Industry supply has overshot demand by a wide margin in the past few quarters, resulting in a collapse in pricing and margins and balance sheet degradation. One boost many hoped for was the normally strong late summer/early fall rush in Germany, but this failed to materialize. Second, overall stock market volatility has increased, which is causing extreme movements in the always volatile solar shares. This will remain the case so long as the market continues to shy away from risk. Given the very weak industry conditions, share prices could be detached from underlying valuations for a while to come. We would avoid investing in solar firms right now, with the exception of First Solar (FSLR).
We expect an industry rebound will not occur until mid-2012 at the earliest. Solar demand growth remains promising in the long term, but near-term growth rates are going to be very modest. We think the industry is looking at 18.5 gigawatts of global demand in 2011 and 20.9 GW in 2012. Anything short of 25 GW probably won't change current dynamics; estimates of inventory in the channel are 8-10 GW, and production capacity ready to be used is still at least 25 GW. This oversupply situation will not be solved by demand growth alone, but will require supply rationalization in the form of bankruptcies, factory closures, and temporary shutdowns.
The Lone Stock With a Catalyst
First Solar is the only solar company whose shares have a clear near-term catalyst: its pipeline of utility-scale projects in North America. We project this business segment to constitute more than 70% of the firm's revenue and 35%-40% of production output in 2012, while also serving as the overwhelming source of near-term earnings beginning in the third quarter of 2011.
Pricing on First Solar's 2011-13 backlog of utility-scale projects was set before the industry downturn, and none are subject to renegotiation. These projects were priced using First Solar's 2008-09 project installation cost levels, which were 35%-40% higher than they are today. Also adding to the bottom line will be the reduction in costs of capital for the 1,070 megawatts' worth of projects that received Department of Energy loan guarantees, which allow the company to realize higher selling prices. Putting it all together, this book of business isn't just going to provide an earnings buffer, but will in fact mint the company a great deal of money. While we project every other company to lose money in 2012, we expect First Solar's earnings will grow, albeit from 2011 figures that have been revised downward in recent months.
The big risk to First Solar's longer-term story is what will happen to the company's profitability and returns when these lucrative projects are completed in 2013. Any new utility-scale deals will be signed at lower prices. Without another large reduction in costs, the company could encounter some major headwinds. But we don't think this risk will be influencing the stock for quite a while, as 2014 is a lifetime away in the solar sector.
First Solar shares were right to drop from their highs earlier this year, given the industry's problems. But as the only solar company that will see profits grow in 2012, First Solar looks to us like a stock that now has been oversold. We think there is an attractive high risk/high reward story that looks set to play out over the next few months.
When Will the Pricing Declines Stop?
Silicon module prices have reached $1.05 per watt, a 40% decline since the beginning of the year, yet stabilization seems unlikely given the desperate situation resulting from oversupply. We see pricing in 2012 averaging $0.90 and would be surprised if pricing in the $0.80s does not occur for at least a brief period. Though this scenario would equate to horrible near-term results for almost everyone, we think it would be very positive longer term for the top companies: More than 50% of the industry will have cash costs greater than $0.90 in 2012, and many will be well above $1.00. A few quarters of pricing near $0.90 very likely would provide the jolt the industry needs: a wave of bankruptcies and a large-scale supply rationalization. This is our base-case scenario: The solar downturn is still in its early innings.
Signs That the Bottom Is Near Solar firms' shares will very likely hit bottom months before the industry itself does. So we are now intently focused on signs that margin stabilization could be a quarter or two away. We haven't seen anything yet, but if a lot of supply is rationalized and 2012 demand grows by the approximately 2.5 GW we project, there is a chance that solar stocks could hit bottom in the first half next year.
We think production rationalization will be the critical driver of a turnaround, in stark contrast to the demand-led recovery of late 2009. We are finally starting to see some signs that this will occur. Though not publicly announced, it is an open secret that most major companies have already shut down or will shut down some portion of production during the fourth quarter. Also, companies are putting cash-management plans into place.
Small players in China are finding it incredibly hard to get their modules financed for use in planned solar projects, which has rapidly dried up their shipments. This is leading to an increasing amount of fringe players shutting down. The critical question that has yet to be answered is whether these shutdowns will be permanent or temporary. In addition, we've heard that drawing on new credit lines even for the major companies in China is becoming very difficult as lenders are far more cautious now.
Though we are very encouraged by such developments, they of course also signal near-term difficulties for everyone involved. These positive signs are but the opening salvos of a battle that is likely to last multiple quarters, but given the dire situation, we view a prolonged downturn as the best possible outcome. For the low-cost leaders to again prosper and profit, bankruptcies, consolidation, and reduced production output in 2011-12 should all be very beneficial in 2013 and beyond.
Companies That Should Benefit From an Industry Shakeout
No matter how long this downturn lasts, a few of the companies left standing will also be in the best position to profit from an industry recovery. Similar to any cyclical industry, the important traits to look for are a strong balance sheet to survive the bad times and a competitive cost structure to profit when the good times return. From our coverage list, the names that screen well are First Solar and Trina Solar (TSL) and, to a lesser extent, Yingli Green Energy (YGE) and JA Solar (JASO). First Solar and Trina both have strong balance sheets and competitive cost structures, while Yingli's balance sheet is a bit more suspect and JA Solar is a bit behind on the cost curve. When the industry turns around, we believe these are the firms that are well positioned to survive the shakeout.
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