I previously published an article on Seeking Alpha, expressing my bullish view on Canadian Solar (NASDAQ:CSIQ) given its global project pipelines and attractive multiples. I believe that many investors felt the same way. Even though many solar panel manufacturers such as JinkoSolar (JKS) and Trina Solar (TSL) have reported better-than-expected revenue and earnings, their stock prices have traded lower since. Many investors still believe that Canadian Solar will return to its intrinsic value some day and Mr. Market has no respect to such a great company.
Canadian Solar, a global leading solar energy provider, should benefit from the accelerated adoption of solar energy globally. Global solar PV installations grew 34% in 2015 and are expected to top 69 GW in 2016, according to the market research firm IHS Technology. Seeing a declining margin in its upstream solar panel business, the company started its transition into the solar project business in 2012 and now has about 10.3 GW solar projects in the pipeline. With a $1.1 billion market cap, the stock looks attractive as analysts expect the company to make $3 billion in sales and $2.5 in earnings per share in fiscal 2016.
Image Source: Canadian Solar investor presentation
To better understand the stock's fundamentals, here I apply the principle developed by Warren Buffett, one of the most successful value investors in the world. According to him, a core test of any business is that whether one dollar invested in the company generates value of one dollar in the marketplace. To apply this principle, I examined Canadian Solar based on the concept of return on invested capital (ROIC). Under most circumstances, ROIC is a superior valuation metric compared to some other metrics such as ROE and ROA.
I hope to find the answer to one question: Has Canadian Solar (and other competitors) been able to allocate its capital wisely and create sustained economic value for its shareholders? If not, what is stopping it from doing so?
As some of you may not be entirely familiar with the term, let us first take a look at the formula for calculating ROIC:
Net operating profit after tax (NOPAT)/Invested Capital (Operating Assets - Non-Interest Bearing Liabilities)
This seemingly simply formula requires many adjustments to the numbers. To help some investors understand the calculation (if you are interested to learn), I will explain some of the adjustments I made. Let us first take a look at the calculation of invested capital.
In Canadian Solar's case, current operating assets include the following items:
- Operating cash - cash and cash equivalents minus excess cash. In this case, I used the rule of 3% of annual sales as operating cash (rest considered excess cash on hand)
- Other operating working capital such as AR and inventory
- Other current assets (unless it is non-operating)and pre-paid expenses
The following items are deducted from the current operating assets
- Non-interest bearing current liabilities such as AR, accrued wages and other current liabilities
The following items are added to the invested capital
- Net PP&E
- Present value of operating leases (this is an off-balance-sheet item, and implied interest expenses was added to NOPAT for consistency)
- Solar power system
- Other operating assets, net other operating liabilities
To calculate NOPAT, we start with the operating income (earnings before interest and taxes) and take out the non-operating part for the company's core operating profit. I made the following adjustments:
- 20.8 million charge related to the LDK (LDKYQ) class action lawsuit is added back
- Added back implied interest expenses on operating lease (present value of operating lease was added to invested capital)
- Converted reported tax to operating cash tax (calculated the change in deferred tax liabilities and reduced the tax shield as if the company is fully financed by equity)
Source: Jeff Cai's calculation of Canadian Solar's ROIC
Canadian Solar had a return on invested capital of 7.12%, 21.65% and 4.49% in the year of 2013, 2014 and 2015, respectively. The company earned a 21.65% return on invested capital in 2014 as it sold many solar projects in Canada for a one-time gain. As a result, this is not a sustainable earnings and return that investors can count on in the future.
My first reaction is that the company is not earning a high level or ROIC, and its ROIC seems quite volatile. Smart investors like Warren Buffett value high return on invested capital with stable cash flow. Canadian Solar, as well as many other competitors, fails this test albeit operating in a growing industry.
The share price hit an all-time high of $41.8 in February 2014 and traded near $40 in May 2015 given the optimism of its yieldco plan. However, the company never succeeded after committing a large amount of capital to the utility-scale solar projects due to the changing market conditions. In 2015, electricity revenue from solar projects only makes up less than 1% of the company's overall revenue, and the business still relies heavily on the sale of low margin solar panels (unless it sells solar projects). As the prices of solar panels continue to decline, Canadian Solar is likely to continue its operation with low margins and returns while committing more capital to its long-term utility-scale projects.
We can also evaluate the company's performance by looking at how much economic profit it is making.
Economic Value Added = Invested Capital * (ROIC - WACC)
I will not discuss the details of calculating the WACC, but I believe most of you will agree that Canadian Solar's WACC (LT debt interest is as high as 13% as disclosed on its most recent annual filing) is much higher than its current average ROIC. As its ROIC is not expected to improve significantly in the near future, the business is not truly creating economic value/wealth for its shareholders albeit its improved earnings.
When Buffett chooses an investment, he stays away from either a bad business or a bad management team. In this case, I believe the problem of low returns stems from the commodity business rather than the quality of management. After all, Canadian Solar is a price taker in the commodity business, and it is hard for any company in the industry to distinguish itself from other competitors. As a result, the only way to improve its return on invested capital is to either significantly lower the operating costs or transition to an asset-light business. However, neither option is achievable in the short term given the industry conditions.
In summary, Canadian Solar is still a great company with a globally diversified power projects pipeline, which should generate stable cash flows for years to come. However, due to the nature of its business and current market conditions, it is difficult for the company to allocate its capital efficiently to earn returns higher than its cost of capital. Simply put, one dollar invested in the business is not creating a dollar of market value for shareholders. In the near term, investors should not have high hopes for the stock until there is a major shift in the competitive landscape or when the business improves its margins consistently.
