Large Write-Downs Continue At Suntech Power

| About: Suntech Power (STP)

Some things never seem to change at Suntech Power (NYSE:STP). Similar to numerous bifurcated earnings reports in the past containing a slurry of good and bad news, Suntech's recent fourth quarter guidance revision continued the trend. On an operational front, Suntech continues to outperform as a leading solar module manufacturer. Yet for all the strides the company has made securing its position in the solar industry, countless corporate mistakes have severely skewed the bottom line. While I cautioned potential STP investors of this trend in my first corporate overview, Suntech has yet raised the bar again with the largest expected US GAAP quarterly loss in the company's history.

The good news is that Suntech raised module shipment expectations for the fourth quarter. The company had originally guided for a sequential shipment decline of approximately 20%. Now quarterly shipments are only expected to decline by roughly 10% from the third quarter's record levels. With gross margin expected to stay consistent from a previously guided 9-11% range, the company should post incremental gross profit relative to its prior guidance. Despite the sequential shipment decline in the fourth quarter, total 2011 shipments are expected to grow about 35% higher than 2010 levels.

Additionally, and perhaps more importantly, in a cash tight sector where so many less competitive companies have shut operations, Suntech announced it had worked down its inventory and net receivables balance by a total of $365m. Consequently, net debt was reduced by $200m, while total cash increased to over $700m from $568m in the third quarter. While Suntech and similar large Chinese solar peers have continually stated revolving short term debt was not a problem, the significant improvement in the company's balance sheet may help dismiss views by some Wall Street analysts who pegged STP as a bankruptcy risk.

The bad news, however, appears horrible at the headline level. As I noted in my recent quarterly review of direct peer Trina Solar (NYSE:TSL), the final quarter of a fiscal year often contains corporate house cleaning. In Suntech's case, total charges are expected to reach $571m, reflecting a myriad of legacy mistakes. Of this total, $407m are goodwill and intangible asset write-downs, $109m are write-offs of bad investments linked to Shunda and Nitol, and $55m in write-downs of the company's own facilities.

The vast majority of these charges are linked to bad strategic and investment planning prior to the first major solar industry downturn in late 2008. During the initial boom, credit was easy especially for an industry leading name like Suntech. In 2007 and 2008, STP was able to raise over $1b on convertible bonds in two separate Wall Street offerings, and as the saying goes, the company spent it like drunken sailors. Total charges since late 2008 have surpassed a billion dollars. As a result, the company has accumulated a high debt level with little to show for it.

Like Yingli Green Energy (NYSE:YGE), Suntech is trying to sneak this huge charge by retroactively applying it to the already reported third quarter. Thus, while fourth quarter results will not reflect these charges, Suntech, like Yingli, will post the largest fiscal loss in the company's history in 2011. In total, the $571m in charges will reduce Suntech's total equity by over a third from the $1.48b reported at the end of the prior quarter.

Suntech's third quarter results were not much of a surprise, given the company had already updated its guidance. Revenues came in at $809.8m, which was only down 2.5% on a sequential basis, despite large declines in module average selling prices ("asp"). Total module shipments rose approximately 16% on a quarterly basis to record levels. Unlike some direct peers, such as Trina Solar, Suntech was able to increase its unit shipments during a very challenging period for the entire industry. Gross margin also came in at 13.3%, slightly above the company's high end guidance of 11-13%.

As usually the case, Suntech's respectable operational results were tainted by non-operational charges. Outside of the recently announced $571m in additional charges to be retroactively applied to the third quarter, the company took a number of charges ranging from accounts receivable to legal provisions, which in total, ballooned operating expenses from an $84m adjusted figure to $123.8m.

In addition, net foreign exchange losses were much larger than clearly guided in the company's second quarter earnings presentation. Somehow, Suntech once again managed to lose money on both passive currency translations as well as active hedging practices. Total net foreign exchange related losses amounted to $66.7m in the third quarter. Factoring out the combined $116.5m in non-operational charges, Suntech's operational loss totaled $1.9m, less than the $15m operational loss estimated in my revised estimates.

Although there is a big difference between Suntech's operational results vs. its US GAAP bottom line, it is important to keep in mind much of these charges excluding net foreign exchange translations are non-cash in nature. As described, the company was merely writing down past mistakes, which have already been paid for. On an operational basis, Suntech as well as other large scale low cost peers are more or less straddling the breakeven mark. This is part of the reason why Suntech and direct Chinese peers have been able to operate at high utilization, despite the vast majority of industry participants being forced out of business. As evident in its fourth quarter update, Suntech's large positive quarterly operational cash flow demonstrates the ability to actively manage cash flow if the situation became necessary.

Due to the lag in blending inventory costs down to lower real-time procurement levels similarly described in my recent Trina Solar review, Suntech's gross margin will be under pressure in the near term. With unit shipments expected to drop about 10% on a sequential basis, continued operational losses should repeat in the fourth quarter. As usual, the estimates below reflect information bounded by direct or implied comments made by Suntech, and do not speculate outside of those metrics. Although a meaningful net foreign exchange loss is included, the estimates exclude additional unannounced non-operation gains or losses and thus, generally represent Suntech's operational results.

STP Q4 Earnings Estimate:

Revenues: $620m
Shipments: 524MW
Asps: $1.13/watt
Unit Costs: $1.00/watt
Core Module Gross Profit: 524MW x .13/watt = $68m
Systems/Other Dilution: $3m
Consolidated Gross Profit: $65m
Consolidated Gross Margin: 10.5%
Operating Expenses: $85m
Net Interest Expense: $35m
Net Foreign Exchange Loss: $10m
Net Loss: -$65m
Diluted Share Count: 180.5m
EPS: -0.36

Although Suntech has consistently held the largest market share in the industry, with an estimated 2.09GW of solar modules shipped in 2011, its past mistakes have allowed much less capitalized peers, such as Trina Solar and Canadian Solar (NASDAQ:CSIQ) in closing the gap. In effect, it is arguable STP squandered over a billion dollars worth of capital with very little to show for it, while smaller rivals were forced to be more prudent in capital allocation, and thus, mainly concentrated on internal expansion rather than external investments. As a result, many peers have approached Suntech's industry leading module manufacturing capacity of 2.4GW. By the end of the first half 2012, Trina's module capacity is slated to match Suntech's. Canadian Solar, which was once dwarfed by Suntech, has already surpassed 2GW of internal cell and module capacity. Unit shipments have also followed a similar trajectory as STP's quarterly shipments, which once doubled and tripled; TSL and CSIQ levels are projected to only be approximately 25% higher in Q4 2011.

In addition, Suntech's module manufacturing efficiencies may have suffered from a lack of focus in strategic planning and development. The company's fully integrated non-silicon module processing costs were $0.74/watt in the third quarter. In comparison, many direct Chinese peers such as YGE, TSL, and CSIQ all noted processing costs 10% lower during the same period. Suntech attributed the difference to higher quality components, which may be the case, since it has been able to generate pricing premiums even at industry leading shipment levels. The company does have plans to reduce this metric towards $0.65/watt by the end of this year, but even so, this target is higher than goals set by peers. As module asps decline, such a wide processing cost difference may put pressure on STP's gross margin moving forward.

Suntech is still likely to continue holding a leading market share position in the photovoltaic solar industry in the near term. Despite numerous corporate missteps, the company's brand is highly regarded for quality and bankability. However, high magnitude capital allocation blunders have eroded the company's once dominate leading position. Although the company still operates well as a solar module manufacturer, investors should continue to discount the same management team responsible these strategic mistakes, as many peers have closed the gap considerably. As a result, and despite STP's current valuations highly discounted towards intrinsic value, other direct peers with better operational track records may offer higher upside after the industry's current consolidation period winds down.

Disclosure: I am long (TSL), (YGE). No position in (STP), (CSIQ).