Despite operating primarily as a single vertical solar cell manufacturer, JA Solar (JASO) has executed well during 2011's extremely challenging environment for the solar industry. The decline in average selling prices("asp") across all crystalline solar verticals since the start of 2011 triggered a chain reaction of shut downs and inventory liquidations. Not only did inventory liquidations cause a collapse in pricing below the manufacturing costs of many producers, but also flooded the channel with upstream component products such as silicon wafers and solar cells. As a result, most single vertical oriented companies quickly found it impossible to generate profits at spot market pricing spreads. Despite approximately 77% of JASO's shipments in the first three quarters of 2011 connected to supplying solar cells, JA Solar was still able to maintain fairly high levels of shipments and at a positive gross margin.
As noted in a prior article, many single vertical peers experienced dramatic declines in shipments during the first nine months of 2011. However, JA Solar was able to increase its overall shipments by 30% year over year for the first three quarters of 2011. For the third quarter, the company was not only able to increase its total shipments annually, but also sequentially which was surprising since some higher integrated peers such as Trina Solar (TSL) noted sequential weakness. JA Solar's business model of remaining primarily a solar cell supplier to top tier downstream industry companies appears to be validated especially given the relative weakness of direct peer competition.
Maintaining high levels of shipments is only one issue. Maintaining adequate levels of profitability is paramount. Quarterly reports by other large US listed Chinese peers such as Renesola (SOL) and LDK Solar (LDK), also primarily a single vertical crystalline component supplier, suggested that even the most cost efficient producers could not generate a gross profit for its single vertical business segment. The situation was no different for JA Solar in the third quarter as implied metrics given in its Q3 earnings conference call suggested all of the company's adjusted quarterly gross profit came from its fully integrated module sales.
As asps started its dramatic descent after 2008's credit crisis, many crystalline solar supplies began higher levels of integration expansion in order to maintain healthy gross margin levels. The solar industry boom of 2010 stabilized prices which allowed even higher cost single verticals to maintain high levels of profitability. This quickly turned into fools gold as companies committed on a single vertical business model found it impossible to operate in 2011's brutal consolidation period for the industry. Many large U.S.-listed Chinese solar companies realized the need for higher integration as potential per watt gross profit levels for the entire value chain could potentially contract to levels where only the largest and most cost effective fully integrated manufacturers remain profitable.
LDK Solar embarked on its extensive integration strategy in mid-2010 despite its silicon wafer segment generating record levels of gross profits. Although hesitant to abandon its label as a leading solar cell manufacturer, even JA Solar saw the need for higher levels of integration by adding upstream wafer and downstream module capacity in early 2010. At the end of 2011, roughly a third of JASO's 3GW cell capacity was expected to be fully integrated towards module production. More importantly as the company looks forward into 2012, over 50% of expected shipments are expected to be comprised of module sales. While solar cell gross margin may return to a normalized positive number looking forward, the company will likely rely on its expanding module business for the majority of its gross profits.
Similar to direct U.S. listed peers mentioned above like Trina Solar, LDK Solar, and Renesola, the main cause for JA Solar's near term margin compression is due to US GAAP accounting. If production costs for its products were computed using real time procurement pricing, the company would generate positive levels of gross margin.
For example, its estimated third quarter solar cell asps were approximately $0.78/watt. Using a blended average for material costs comprising of higher cost inventory on hand combined with more recent lower cost procurement, I estimate JASO's solar cell unit cost was approximately similar to its selling prices thus yielding zero gross margin. In fact based on the company's implied gross profit generated from module sales, revenues from its solar cell division may have generated slightly negative margins in the third quarter. However, silicon wafer asps averaged around $0.55/watt during the quarter which would have yielded, excluding high carrying cost inventory, an in house solar cell unit cost in the low $0.70s/watt, or a high single digit gross margin at a solar cell asp of $0.78/watt.
Like many direct peers, JASO also recorded an inventory provision in the third quarter totaling $21.7m. This combined with relatively lower level of inventory vs. U.S.-listed Chinese solar peers should help JASO realize an inventory blended cost closer to spot level prices. However it is likely the company will not fully blend its inventory carrying costs to real time procurement pricing until sometime in the first quarter of 2012. Thus while JASO's gross margin should improve from third quarter levels, it would likely not represent normalized levels high enough to maintain corporate profitability.
While JA Solar did revise fourth quarter shipment expectations up dramatically from 310-330MW to 390-410MW, quarterly shipments represented utilization levels around 60%. Underutilization combined with higher than normalized blended inventory costs will likely generate an operational loss for JASO in Q4. Based on metrics stated or implied in JASO's third quarter conference call, a fourth quarter earnings estimate has been compiled below. As usual this estimate is bound by statements given by the company and do not speculate beyond these ranges. Although minor non-operational items are included, the estimate below generally represents JA Solar's operational earnings.
JASO Q4 Earnings Estimate:
Shipments: 250mw cell, 25mw tolling, 130mw module
Asps: $0.58/watt cell, $0.22/watt tolling, $1.00/watt module
Unit Costs: $0.54/watt cell, $0.22/watt tolling, $0.90/watt module
Gross Profit: 250 x .04 = $10m + 130 x .10 = 13m
Gross Margin: $23m / $281m = 8.2%
Operating Expenses: $20m
Net Interest Expense: $18m
Net Foreign Exchange Loss: $3m
Net Derivatives Gain: $2m
Tax Benefit: $1m
Net Loss: -$15m
Share Count: 185m
Most of the expected non-operational items listed above should be small and cancel out in the fourth quarter. With a slight depreciation in the euro during the quarter, the company should record a small net foreign exchange loss. With a small decline in the company's share price, total mark to market adjustments for items linked to its convertible bonds should generate a small gain. A slightly higher fully diluted share count representing the full impact of an additional 30.9m shares issued in connection to JASO's acquisition of Solar Silicon Valley instead of the quarterly weighted average figure estimated could also dilute the company's expected earnings per share("EPS") loss slightly.
Of course as witnessed by many direct peers, JA Solar could also post a myriad of additional charges in the fourth quarter. Although less likely, another inventory provision could repeat. As companies typically want to close the fiscal year with a cleaner book, other provisions such as accounts receivable and prepayment advances write downs which were taken in the third quarter could repeat.
In contrast, there may also be some potential positives in the fourth quarter. Similar to several other U.S. listed Chinese solar companies witnessing depressed valuations, JA Solar also announced a share repurchase program for up to $100m. Based on the reported diluted share count in the third quarter vs. the total reported in its annual report, some shares may already have been repurchased. Further reduction in JASO's fully diluted share count could incrementally increase any potential positive EPS figure via an operational surprise or non-operational one time gains such as debt repurchases at discounted pricing as the company has done in the past.
2011 was a horrendous year for many solar companies and JA Solar was no exception. However despite being heavily exposed to a single vertical, the company executed fairly well in limiting potential damage done by the industry's brutal consolidation. JA Solar's position as primarily an OEM supplier helped keep overall expenses at a lower level compared to branded peers which not only limits losses during down cycles but should also allow for quicker reacceleration of profits during up cycles. While total 2011 unit shipments were only expected to increase slightly on an annual basis, JASO was able to keep shipments at a high level among industry leaders when many single vertical peers saw dramatic market share loss. The ability of higher integrated peers to grow total shipments over 50% in some cases demonstrated the importance of further integration for JA Solar. With an expected ratio of over 50% module vs. cell shipments in 2012, profitability should increase once market pricing normalizes to sustainable levels.