Producing traditional solar cells is basically hell right now. There is overcapacity, oversupply, demand in the main markets is growing less than many predicted a year ago, prices have fallen steeply and there are big inventories building up.
And the problem is, none of this is likely to go away anytime soon. To some investors, this comes as a bit of a surprise. After all, isn't this one of the sectors of the future? Isn't demand relentlessly rising as a result of relentlessly falling cost and prices?
Well, yes, all that is going on. In fact, the price falls have accelerated this year, bringing grid parity, the point at which solar panels can compete on price with existing electricity tariffs, tantalizingly close (even though it can be argued that grid parity is a little bit of a silly concept).
David Crane, the president and CEO of NRG Energy observed, "In the last two years, the delivered cost of energy from PV was cut in half. NRG expects the cost to fall in half again in the next two years, which would make solar power less expensive than retail electricity in roughly 20 states, he said. [Greentechmedia]
There are many who argue that grid parity is near, see for instance here, and here. Some even argue, in considerable detail, that it already has arrived. If that is true then the market might become much bigger but there is sufficient insecurity over the timing and the meaning of the concept of grid parity that it should keep the solar investor from counting his chickens before they hatch.
Yet the global market outlook isn't particularly bright:
Compared to the 170 percent growth rate for new photovoltaic installations in 2010, 2011 was not as strong for the industry. Newly added capacity in 2011 is estimated to have reached 23.8 gigawatts (GW), up 34 percent from 17.7 GW in 2010. But 2012 is not expected to see as much growth. [PV Magazine]
There are subsidy cuts in Germany, the US, Australia and Japan. Against that, there is solid growth in many markets, but these are just largely offset by Europe, which is still the biggest market by some margin.
IMS Research further predicts that demand from Germany and Italy alone will fall by three GW in 2012, and Europe’s share of global demand will fall from its levels of 80 percent in 2010, to 56 percent in 2012. [PV Magazine]
And of course we have the trade dispute between America and China, where the main exporters are located. This could put a further damper on the industry. There will be a significant consolidation in the industry, which counts some 250 wafer and cell producers and more than 400 module producers.
What disappointed investors are missing is that this industry is basically producing a commodity. While there are a host of different technologies but these can be classified along a continuum linking price with conversion efficiency. The thin film technologies are usually cheaper (due to more automation in production), but they're also somewhat less efficient in converging sunlight into electricity.
Is there a way out of here?
Well, investors could just be patient until growth will catch up with existing production capacities. But that might take some considerable time. There is one good sign though, equipment makers expect a very tough time. PV manufacturing equipment is set to half in 2012, which means that there is finally a dramatic slowdown in the relentless build-up of new production capacity.
But it's going to be some time before the present excess inventory and overcapacity is worked through the system, especially as 2012 isn't likely to be a stellar year for demand.
Some argue that the lack of pricing power is a marketing problem. Better brand recognition could be one way of achieving differentiation (instead of 'Intel Inside' it could be 'Trina on top') but somehow we doubt it. People buy this stuff mainly to save on energy cost and perhaps also to feel good about themselves, but the main metric by far is price per watt.
One of the biggest barriers for the consumer market to take off is the fact that most of the costs are up-front. There could be innovation in business models here, and in fact this is already happening. Companies are interposing themselves between the solars and consumers, pre-financing rooftop installations and panels, charging consumers a fee lower than the grid in exchange for pocketing the 30% federal subsidy and locking in customers for a long time.
These models are interesting in several ways. Not only do they remove the biggest barrier for the retail consumer, they also strongly suggest that with the 30% subsidy, grid parity is here already. If these companies can offer energy prices just below grid prices and absorb all other cost then solar energy can be 30% more costly than the grid at most.
Of course, these companies might get better financial conditions compared with end consumers and we know that since most (if not all) costs of solar are up-front, the discount rate matters a great deal, so some of the advantage is situated here. But if models like these make sense in the markets with 30% subsidies, grid parity can't be far off.
To provide some perspective; cell prices have fallen 59 percent since Dec. 27, according to Bloomberg New Energy Finance.
In previous periods of oversupply, like 2009, competition was somewhat mitigated because of the way project financing works. Banks often had a (restricted) list of 'bankable' suppliers and this kept high cost (mostly German) producers alive despite a world oversupply.
With the establishment of track records by the Chinese, The list of bankable suppliers should be bigger now, so that's no longer going to hold up much competition. In due time, a solar roof might be a standard option of a mortgage.
In essence, companies can escape such a commoditized industry because of two things, process innovation (leading to cheaper products) and differentiation.
We have to say that the market does not look particularly bright for diversification efforts. In fact, the price declines are squeezing technological alternatives that have ventured out into the production stage. We have the Solyndra fiasco, which was widely reported. Much less widely reported were the struggles of solar thermal energy.
A whopping $3B of gigawatts of concentrated solar projects, a technology which concentrates solar light via giant mirrors onto some substrate (usually molten salts), has been converted to photovoltaic (PV) projects. It simply can't compete with PV technology, despite enjoying advantages in energy storage.
The relentless price declines seem to lead the industry into what's called a dominant design, where the basic parameters of the technology are more or less fixed and competition shifts toward process innovation.
Enter the process kings
And it's exactly here, in the new competitive field, where new competitors enter, competitors that could very well have superior capabilities. Foxconn, the biggest electronic contract manufacturer in the world (and known for the iPhone production) is entering the industry. It certainly has manufacturing capabilities, and it certainly should be a bankable supplier.
It is also accustomed to operate on 5% margins, rather than the 20%-30% margins the solar industry was previously banking upon.
And then there are the Koreans coming. Other process kings, the likes of Samsung and LG, and a host of others. If, as it seems, these entries are serious, we might be witnessing a rather colossal shake-out, the one that was predicted for 2009 but never really materialized.
The way for solar companies to escape this onslaught if they don't have the economies of scale and learning of the process kings is to innovate the product. This is realized even in some of the biggest solar companies of the world:
The solar industry is entering a new era in which investment in R&D--and the new technologies it produces--will be crucial for solar companies to survive, says Stuart Wenham, the chief technology officer of Suntech Power Holdings (NYSE:STP), based in Wuxi, China, one of the largest solar panel manufacturers in the world.
But of course, as an existing big player they have to struggle with the familiar trade-off between efficiency and innovation:
But don't expect radical changes to solar panels, at least for the next several years, he says. The best new technologies will be those that can easily be integrated into existing production lines and work with existing suppliers.
So the more radical stuff is likely to come out of university labs and start-ups. This isn't much different from most other industries. Could it be that the solar industry is maturing, and will enter adulthood after the wild teenage 'shake-out' years will be behind it? Not yet, as it still cannot do away entirely with subsidies, but that day is inexorably nearing.
What to do with solar shares?
We would advise to sit on the fence. Yes, there could be signs that the worst is behind us, but on the other hand, entry of new big players and existing overhang in inventories and capacities, together with any possible worsening situation in Europe, mean there are just too many risks to dive in. Things could very well get worse before they get better.
We prefer to have our feet a little more on the ground, even if that means we'll miss the first upside.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.