Ramifications Of U.S. Commerce Department's Solar Anti-Subsidy Decision

by: Investing Hobo

Earlier this week, the U.S. Commerce Department released a preliminary decision on countervailing on imports of solar cells from China, which will result in import duties ranging from 2.9% to 4.73% for Suntech Power (NYSE:STP) and Trina Solar (NYSE:TSL) respectively. All other Chinese exporters are subject to an import duty of 3.61%. China's top three module producers, Suntech Power, Yingli Green Energy (NYSE:YGE), and Trina Solar promptly issued a press release in response. While the initial tariff imposition is much lower than widely expected by industry observers, it sends a wrong message, which could lead to greater solar industry trade friction between China and the U.S. The overall effect could result in an incrementally negative impact for U.S. solar-related companies.

The validity of China illegally subsidizing its solar companies and dumping of solar products into the U.S. will not be discussed in great detail in this article. More specific details have been discussed in my recent article, which examined past solar related trade between the U.S. and China. China's three largest module producers listed above are all U.S. listed public companies and therefore not only must abide by SEC regulations but also use the same U.S. GAAP accounting practices used by U.S. solar companies with financial results audited by leading global big four independent auditors.

With financials open and transparent, it would appear difficult to accuse China's leading module producers of dumping. While STP, YGE, and TSL for example experienced severe margin compression, each reported positive gross margin throughout 2011. Module pricing at these firms has consistently remained well above spot market averages. In many cases, spot prices for solar products even fell below the production costs of the industry's most efficient manufacturers. Most likely, the "dumping" occurred among companies forced to shut down and liquidate inventory due to uncompetitive cost structures. For example, in the fourth quarter of 2011 TSL reported module average selling prices ("asp") of $1.01/watt while STP and YGE's earnings implied asps above $1.10/watt. However, spot market pricing as monitored by PVinsights quoted average module asps of $0.90/watt with the lowest offer at $0.70/watt. China's top three suppliers sold modules at a 10-20% premium over market averages where the lower price band was even below the production costs of each individual company.

Government related subsidies or grants have also been clearly outlined in respective annual reports, which relative to overall revenue represented a very small percentage. In the past three audited fiscal years. Total government related grants for STP, YGE, and TSL combined amounted to just $64.3m vs. a combined revenue of approximately $14 billion for the same period. Ironically Solarworld, the lead company that brought claims against Chinese solar companies to the U.S. Commerce Department last November, received at least $100m of subsidies and grants in the past three years alone.

Other claims ranging from discounted credit, preferential tax treatment, and subsidized utility are also easily debunked through examination of public and audited financial results for these U.S.-listed Chinese solar companies. The average interest rate paid by STP, YGE, and TSL mirrors China's interest rate of around 6%. In contrast, equity and debt-related financing in the U.S. markets has typically yielded lower interest rates for both Chinese and U.S. solar companies. Other claims regarding disproportionately large credit lines Chinese companies enjoy have also been inaccurate and discussed in greater detail in a prior article.

In terms of taxation, STP, YGE, and TSL paid an average tax rate of 14.6%, 12%, and 14.2% respectively in 2008, 2009 and 2010. First Solar (NASDAQ:FSLR), the largest and most profitable U.S. based solar company, paid on average only 4.7% in taxes for the same corresponding period. It is also important to note FSLR's nearly $1.4 billion of pretax U.S. GAAP net profit in these three years surpasses the combined totals for China's top three module manufacturers.

What is interesting about China is that corporations generally pay higher utility rates than residential consumers, which is typically in direct contrast to western companies. As detailed in another article, U.S. based Hemlock, one of the world's largest polysilicon producers, received state electricity subsidies, which is extremely beneficial for high electricity consuming polysilicon production. U.S. listed Chinese solar companies that did list electricity costs in annual reports paid approximately $0.11/kwh, a rate higher than the Chinese national average and even higher than the majority of states in the U.S. Among U.S. listed Chinese solar companies, only LDK Solar (NYSE:LDK) received provincial electricity subsides in the past but even in this case it is ironic the national government since mid-2010 has cracked down on any local government electricity subsidies [LDK's most recent annual report, page 20] in an effort to curtail usage for high electricity consuming industries.

At least through examination of audited financials for these public companies, it is hard to see how any U.S. listed Chinese solar company received preferential subsidies relative to U.S. counterparts. Perhaps this played a role in the U.S. Commerce Department's surprisingly low initial tariff imposition. Despite what appears to be more of a symbolic move by the U.S. government, even these minor tariffs could result in more serious consequences.

As noted in my prior article, the U.S. enjoyed a large solar trade surplus with the rest of the world including China during 2010. Given extremely low module exports to the U.S. in years prior to 2010, the surplus with China was even larger as many Chinese solar companies purchased manufacturing equipment and materials from the U.S. JA Solar (NASDAQ:JASO) specifically stated in its Q3 2011 earnings conference call, that the U.S. had enjoyed a cumulative trade surplus with the company.

While past trade surpluses will inevitably turn into deficits as U.S. solar installations grow and it imports more modules including ones produced in China, it is important to realize as much as 80% of a crystalline solar module's manufacturing cost is comprised of raw materials. STP, YGE and TSL have all sourced portions of their raw material requirements from the U.S. including polysilicon as well as other consumables. As the decline in module asps compress gross margins to razor thin levels, any additional costs such as tariffs may cause Chinese companies to seek lower procurement costs. Already a recent trend, large scale Chinese solar companies have been forced to horizontally integrate and produce more of their consumable materials internally. The overall revenue gained from these tariffs may be lost by U.S. solar material suppliers.

In addition, if U.S. action escalates into a larger trade dispute, China may impose its own tariffs on U.S. solar product imports. This would almost guarantee the stoppage of any material import and usage from the U.S. because industry margins have already dropped to levels where any additional costs cannot be absorbed. Just as China's polysilicon industry has grown in the past few years from literally nothing, manufacturing equipment, which has been a major U.S. export, may shift away from the U.S. to other regions or even produced domestically in China. As the industry has shown in the past, anything resulting in higher costs has quickly been marginalized. Non-market steps taken by the U.S. government could disturb the value chain and harm portions of the U.S. solar industry that have successfully remained competitive in the past.

Although the U.S. Commerce Department's anti-subsidy ruling is only preliminary with an additional preliminary anti-dumping ruling scheduled for May 16, the government needs to tread very carefully and consider the ramifications beyond the small solar module manufacturing base in the U.S. It is critical the U.S. does not politicize the situation and that it base any decisions on factual evidence. The entire value chain stretches beyond module production and as component pricing declined, the economic justification for solar projects has become more compelling. Long-term value investor Warren Buffett's recent investment in solar projects is perhaps the best indication solar in the U.S. has reached an inflection point. This level of critical mass has been reached only through lower costs, which the entire industry has worked to achieve. Below this pricing threshold, U.S. solar installations could be set to expand exponentially, which would generate revenue far beyond a solar module's cost. In contrast, non-market government action could delay the deployment of solar in the U.S. In just the past three years, solar installations in China have expanded from near non-existent levels to surpassing the U.S. in 2011, and it has become the world's third largest solar market.

Disclosure: I am long TSL, YGE, LDK.