A Sunny Future with Cloudy Economics
A few months ago, I was on a flight from Boston to Los Angeles when I stumbled across the Bloomberg Businessweek article, 'Musk vs. Buffett: the Billionaire Battle to Own the Sun', complete with a photoshopped image of the two men wrestling in a ring. This entertaining article was media sensationalism at its best. It also managed to confuse a critical issue: it framed the conflict in Nevada as a power struggle between two companies with competing interests in solar. When in reality, it was a struggle between a solar provider (SolarCity (NASDAQ:SCTY)) and a solar customer (NV Energy).
According to the International Energy Agency, by 2050, solar power is expected to become the world's largest source of energy, with solar photovoltaics and concentrated solar power contributing over a quarter of the world's energy needs. To achieve this, solar PV capacity in 2016 would have to grow a hundred fold over the next 35 years.
That's the sort of growth potential that would tempt any investor and explains why solar receives so much coverage in the financial press today. But it's precisely this enthusiasm that worries me. There I was, sitting on a plane reading about the bright future of the solar industry, when just 50 years ago people spoke of airlines with the same degree of enthusiasm. And yet despite the exponential growth of the airline industry as a whole, every legacy airline has managed to go bankrupt at some point or another.
If we accept the premise that the future of the solar industry is bright, then the next question that the long-term investor must ask themselves is: who does the sun shine on - the solar companies or their monopoly-like, completely price elastic customers?
The principles behind businesses are simple. At the end of the day, what a company is looking for in any industry is pricing power. A business achieves this pricing power by building a competitive advantage through a cost leadership or differentiation strategy that's difficult for competitors to emulate.
Even a cursory Porter Five Forces analysis of the solar industry yields results that are not promising:
Solar is a commodity industry where barriers to entry are low, the threat of substitute products is high (e.g. wind) and the power disproportionately favors its suppliers (e.g. raw material providers) and customers (e.g. price elastic, monopoly-like utilities and households). It's also an intensely competitive industry where there's a constant risk of oversupply.
How does a solar company achieve a sustainable competitive advantage under these conditions? A cost leadership strategy seems unlikely to work for two reasons:
- Solar panels are relatively inexpensive to manufacture. This limits the upside from mass production and economies of scale.
- Incremental cost improvements are unlikely to offset increased government subsidies and lower labor costs in the developing world (e.g. China and India).
In the long term, any North American producer's claim to being "a cost leader" is likely a temporary phenomenon.
What about differentiation? Until solar companies figure out a way to make witty commercials starring a lizard with a British accent, the only path to a sustainable competitive advantage in the solar industry is through technology, or more specifically, through superior energy conversion efficiencies.
To achieve a true competitive advantage in this crowded space, solar panel technology needs to be substantially better than the field. Think the Tesla Model S vs. gasoline cars. Incremental efficiency improvements just won't cut it when the lead time to imitation is short.
Surveying the Field
Observing the cycle of enthusiasm and PR is like watching a dog eating its own feces. The more enthusiasm investors have for an industry, the more PR is generated to feed that enthusiasm. And on and on it goes.
There's not a day that goes by without some sort of innovative breakthrough in solar cell technology. Most of these claims are either overstated or happened in some distant R&D laboratory, years away from being achievable in the real world.
The solar photovoltaic (PV) industry can be divided into two segments: conventional silicon cell manufacturers and thin layer solar cell manufacturers. The trade-off here is straightforward: conventional silicon cells are costlier to produce but more energy efficient than thin layer technologies using cadmium telluride (CdTe).
In the following section, I'll look at the technology claims made by the leader of each segment to determine whether a potential competitive advantage exists.
Tearing Down the Field
As the self-proclaimed leader in solar cell technology, SunPower (NASDAQ:SPWR) boasts a cell efficiency of 21.5%. What that translates to at the module level is unknown. If SunPower's competitive advantage rests in its innovative technology, let's evaluate the claims it makes in its most recent annual report under the sub-heading 'Technology':
"Superior performance, including the ability to generate up to 50% more power per unit area than conventional solar cells."
This claim is misleading. SunPower is attempting to differentiate itself from conventional silicon cell producers even though its panels are made from the same materials. The superior performance is largely a product of design. SunPower utilizes the Maxeon design, which involves changing the electrical connections so that the silver wiring is eliminated, allowing the entire face of the cell to be covered with electrodes. The 50% performance figure is overstated. In practice, replacing conventional solar cells with SunPower cells has yielded only a 25% improvement in performance.
What SunPower also fails to mention is that the use of such a design raises the cost of materials and construction. This cost to performance trade-off is material to a business operating in an industry where its customers are extremely price sensitive and competition is intense.
"Superior aesthetics, with our uniformly black surface design that eliminates highly visible reflective grid lines and metal interconnection ribbons."
Investors should be wary when a self-proclaimed "innovative" company touts its product's 'superior aesthetics' as its second bullet point.
"Superior reliability, as confirmed by multiple independent reports and internal reliability data."
Most solar panel systems available on the market are fairly reliable. Not a material advantage.
"Superior energy production per rated watt of power, as confirmed by multiple independent reports."
If we take SunPower's 21.5% cell efficiency figure at face value, then fair enough. But even a cursory examination of data from two years ago shows that SunPower's numbers are not light-years ahead of the field.
It seems clear that for a technological leader in its industry, SunPower has been leaning on its Maxeon design concept for quite some time. Given the incremental advantages of its technology, it's not unreasonable to assume that SunPower's position will erode over time, and that its financials will eventually catch up to the harsh realities of its industry.
First Solar (NASDAQ:FSLR) is often touted as a conservative pick in the solar market and there are a lot of legitimate reasons to think so. It's been a relatively stable player for over 15 years, with a strong balance sheet and a management team that appears proactive in reining in overexpansion.
After the high profile bankruptcy of Solyndra, First Solar is the only major player left in the market producing a thin layer solar cell. The historical advantage of thin layer solar panels is that they're far cheaper to produce than conventional silicon cells, and explains First Solar's stable operating history since the early 2000s. But with recent cost reductions in silicon manufacturing, the historical advantages of thin layer technology comes into question.
The downside to thin layer solar panels is their lower conversion efficiency. In recent years, the company claims to have created a record-breaking experimental cell with a 22.1% efficiency in a laboratory. This information is meaningless without some idea of its performance in practice. The company's commercial line of solar cells has a conversion efficiency of only 16.4%, which is at the lower end of performance for traditional silicon cells.
Given the vanishing cost advantages and dubious efficiency numbers, investors have to question whether thin layer cell technology will still be viable 10-20 years, when costs of silicon continue to plummet and more players flood the market.
The clincher for me was when Warren Buffett-owned Nevada Energy struck an unprecedented power purchase agreement with First Solar to buy energy at 3.87 cents/kilo watt hour back in 2015, undercutting the previous record deal of 4.6 cents/kilo watt hour just a year before. That's a 20% price reduction negotiated within a 12-month period. Consider this and weep for the long-term profitability of First Solar and the solar business.
Speculation vs. Investing
I've avoided the SunEdison (SUNE) bankruptcy for fear of clouding my main argument, which is that the solar business is subject to extremely unfavorable economic forces that benefit solar customers at the expense of solar cell providers.
My hypothesis on SunEdision is that the economic incentives that drove it to bankruptcy are the same ones driving solar companies to wage pointless PR battles to break cell efficiency records in laboratories. And like pre-crash oil companies, it's hard to sift through the BS when the industry is practically swimming in it.
Over the next 50 years, the smart money is on the solar business growing at an exponential rate. But I would hesitate to invest in a solar company for one simple reason: it's difficult to predict a winner under these conditions. The solar industry is young and its rules are still largely undefined.
And for a long-term investor, when you don't like the rules of a game, you don't have to play.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.