Investing In Solar ETFs Vs. Individual Solar Companies

by: Rodolfo Avalos

Given the current shake out and the grim outlook of the Solar Industry, one has to wonder whether investing in a solar ETF is a much better alternative than investing in hand-picked individual solar companies. Just recently, I published a Seeking Alpha article that discusses how a highly leveraged Chinese solar company (LDK Solar) operating with significant negative working capital has been able to survive (so far) the severe downturn of the solar sector. It makes the compelling point that the Chinese government is behind this company's survival and is actively providing support (financially and politically) to other top-tier solar companies.

In the Q&A session of the First Solar's 2012 Guidance/Update Call, Mike Ahearn, Chairman of the Board and Interim Chief Executive Officer, when asked to comment on the repercussions for some of the recent disputes between China and U.S. around some of the solar policies, stated that China has a big energy problem due to its already-high (and growing) carbon dioxide emissions situation. He further added the "Chinese government is sincere in their desire to shift on a going-forward basis, portions of their incremental load to renewables as much as they possibly can, consistent with good economics and so forth. That means there’s a pretty big role for solar. I mean, not just to support Chinese manufacturers, but to meet real energy needs. It's got to hit a price point, and it's got to be scalable."

Such comments, backed by the growing evidence that China is in fact getting into full-support mode for the polysilicon & solar industry, would make you believe that investing in any individual Chinese solar company (as highly-leveraged as they could possibly be) is currently a "safe and smart" move. The old adage heavily used and applied to the U.S. economy is "Do not fight the Fed." A similar one can be said for the Chinese government vis-a-vis the solar situation. "Do not fight the People's Republic of China." The market has probably started to realize this If you consider LDK Solar's ADR sharp price increase off the lows in recent weeks, despite its mind-boggling debt-to-equity ratio, current operating losses, and even when other solar companies have already begun to cut Q4 2011 and full 2012 estimates. But be wary that such an assumption could be misleading and provide a hard pill to swallow for existing shareholders, since a company can still file for bankruptcy protection and emerge later on with a leaner, cleaner balance sheet. This would essentially wipe out all current shareholders and prevent them from benefiting in the company's "eventual" riches.

In the same 2012 Guidance/Update Call, First Solar announced a shift of strategy and discussed a 3-year plan to slowly get out of the subsidized markets and address only sustainable, non-subsidized markets with utility-scale solar solutions. In theory, this plan sounds compelling and could give First Solar a first-mover advantage over many of its competitors. The problem is that First Solar would have to execute this plan almost flawlessly, and overcome 3 major hurdles - the ability to reach a Levelized Cost of Electricity (LCOE) of $0.10 to $0.14 a kilowatt hour the most important one. Whether it will be able to reach this price-point similar to subsidized levels at scale remains to be seen, but I would also throw into the risks bag that despite First Solar's low manufacturing costs and versatility, its thin-film technology is less efficient and utilizes bigger retail space than its monocrystalline/polycrystalline silicon counterparts. With the current bloodshed in the polysilicon price, First Solar's cost advantage is very quickly eroding to the Chinese and other polysilicon-based solar competitors. Helios Q, another fellow contributor to Seeking Alpha, did an excellent job summarizing the cost of production for several solar companies following their Q3 2011 numbers, including First Solar's. In the article, you can see how First Solar's competitors are quickly catching up in their cost of production and even surpassing that of First Solar. Granted, First Solar has been consistently delivering on promises and has earned the trust and business of some of the most respected companies in the utility industry (including APS, Exelon (NYSE:EXC), GE, NextEra (NYSE:NEE), NRG, PG&E, midAmerican, etc.), but that doesn't mean that the Chinese competitors cannot also quickly catch up and aggressively follow a similar strategy on the Systems business in any new market.

To add insult to injury, just last week it was published that one of the chemists from the University of Texas at Austin has discovered a new way to double solar panel efficiency (reaching up to 66%) by utilizing a different material (namely an organic plastic semiconductor called "Pentacene") that converts solar's photons to more electrons than regular photovoltaic panels.

The fact of the matter is, nobody really knows which solar companies will be pushed out of business or be forced to merge. Nobody also knows how long it will take for the solar industry to improve even when the forecasted solar global demand for the next 5-10 years is quite promising. There's no doubt however, that in the long term, the solar industry will thrive and shine. There's also no doubt that many of the current solar companies (especially the large-scale ones) will survive this downturn. As an investor seeking to benefit from the long-term positive outlook of the solar industry but without incurring unnecessary and outsized risks, one must analyze and consider the possibility to invest in Solar ETFs until the solar waters get clearer. Two possible pure-solar ETFs to invest in are The Guggenheim Solar ETF (NYSEARCA:TAN), which tracks the performance of the MAC Global Solar Energy Index, with First Solar (NASDAQ:FSLR) being the 2nd top holding (11.26% of net assets as of this writing) after having lost the #1 spot with the recent wild ride in the stock; and Market Vectors Solar Energy ETF (NYSEARCA:KWT), which mirrors the price and yield performance of the Ardour Solar Energy Index, with First Solar (FSLR) and Trina Solar (NYSE:TSL) occupying the 3rd (7.89% of net assets) and 4th (7.46%) spots respectively. The most important Chinese solar companies (capacity-wise) are also within the first 10 spots in each ETF. As a result of the current downturn in the solar sector, there's a lot of value in several holdings of both ETFs. As of September 30, 2011, the Price/Earnings ratio of the TAN ETF is 3.5x and its Price/Book ratio is 0.6x. Considering the very similar holdings on both funds and the continued decline in the solar sector over the last 2-3 months, one would expect to have somewhat better/compelling valuation metrics in both ETFs.

One big drawback for these funds is that they are not highly liquid vehicles. The bid-ask spreads in the options of both ETFs are quite wide, and the AUM (Assets Under Management) are small in comparison with other highly liquid ETFs. As of December 23, 2011, TAN has $59M (millions) USD whereas KWT has only $10.3M. Another aspect to consider is the Net Expense Ratio (0.65% in both), but when compared with other actively-managed ETFs this ratio is fairly decent.

Many of the solar companies currently present extreme depressed valuations and one feels tempted to selectively pick and invest in a few of them, provided you have enough time to do your due-diligence and substantial research. Even so, an individual investor will always be at a disadvantage when it comes to the amount of resources, tools and information that professional money managers have access to in the financial markets. To be succinctly clear, there could be still more pain coming in the near future, but the significant declines in prices could make it plausible that solar equities could turn up before a recovery starts. However if you're a long-term investor with limited time to perform your own research, firmly believe in the solar industry as one of the world's most important renewable energy resources despite its wild up-and-down fluctuations, and wish to mitigate part of your risk yet still capture the potential upside of the resilient solar companies, the solar ETFs might be an option for you.

Disclosure: I am long LDK, JKS.

Disclaimer: This article is intended to be informative and should not be construed as personalized advice as it does not take into account your specific situation or objectives.

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