Investors in First Solar (FSLR) keep getting more bad news. The recent earnings report was disappointing and pending changes in German subsidies will make that a difficult market for a long time.
First Solar is now in a transition from subsidy-driven growth to a more sustainable value proposition in sunnier climates and more rapidly growing economies. This transition is going to be expensive and take time. Measuring investor patience won't be easy. Although solar cell efficiency has a long way to go, First Solar remains at the forefront of what is possible (14.5%) using production-scale technologies.
Part of what is tantalizing about solar technology is the potential for an effect like Moore's Law to begin to accelerate improvements in performance. At this point it's a fantasy but there have been some encouraging experience and science that suggests the current technology could be at least 5x more efficient in the very long term. That would result in a rather disruptive 15 entc manufacturing cost per watt. As it stands now FSLR sees 50 cent cost per watt in their current 3-year plan which is a material advance.
Gross margins at the company are also suffering more than normal due to higher warranty costs that will eventually be worked out, creating an opportunity for expanding gross and net margins that investors will appreciate.
First Solar's market advantage is building large scale systems which utilities demand for solar to "make a dent" in energy supply. We won't go through all the obvious advantages of solar for many use cases but they are substantial and lower prevailing costs will continue to drive adoption and ROI for multiple players in the market.
The revised First Solar strategy will take years to play out and investors will focus more on the risks to near-term revenues and profits rather than the ultimate achievement of large unsubsidized installations in growth economies.
What we like about the current turmoil:
1. Management isn't whistling past the graveyard like some other previous market leaders (Research in Motion (RIMM) and Nokia (NOK) come to mind!)
2. The company will continue to grow and generate substantial earnings and cash flow during this difficult period.
3. Ultimately costs and efficiency could create a sustainable growth business without the dependence on subsidies.
4. It appears that other large players are scaling back investments and their aspirations in the solar market. This would help restore a healthy supply/demand balance.
5. The valuation is low. Our IV suggests a $90 stock price on an 8x P/E. FSLR doesn't pay a dividend now but we could see it happening during our investment horizon.
What we don't like:
1. The shares could be "dead money" or worse for most of 2012. The stock may be pressured by continuing news about reduced subsides and funding challenges for planned projects.
2. New CEO could be a positive or negative catalyst. We don't know who it will be but in the past people with great resumes have been disappointing. Will they be a level-5 leader or a dud?
3. Cutbacks in R&D and alternative technologies could jeopardize the technology leadership that First Solar enjoys. They still have substantial resources to buy companies that show promise but at 15% efficiency there is lots of room for improvement.
4. The market reminds one too much of the DRAM market. The "gorilla" back in the 1990's was Micron (MU) which had a massive run based on favorable industry conditions that not only didn't last but never returned thanks to competition and the commodity nature of memory.
5. Estimates still seem high. The relationship between reduced or eliminated subsidies and current estimates is not clear. For example the ramp down on subsidized might be steeper than what analysts expect and the uptake of new non-subsidized business might take longer.
1. Energy prices are volatile. Higher oil prices and increasing environmental costs for coal drive demand for alternatives like solar.
2. FSLR is a fairly heavily shorted stock (14m short now out of 86m out) and there remains a contingent of "cloak and dagger" market players around the name.
3. Alternative energy, global warming and technology leadership are all political themes and this is an election year.
On balance the current stock price versus our IV estimate tends to dominate the analysis. It doesn't mean that there isn't more potential downside in the stock if near-term challenges intensify but it does suggest that quite a bit is already priced in.
The CEO appointment is likely to be the next potential positive catalyst but comes wrapped in continuing bad news about German subsidies and current project financing risks.