The Solar Bubble Has Officially Burst - Survivors Will Ultimately Capture More Market Share

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The King is dead, long live the King. Just three fiscal years removed from being the largest crystalline solar cell manufacturer in the world, German based Q-Cells SE (QCE.DE) on April 3, 2012 filed for insolvency proceedings. The news was far from a surprise given the company's share price had already dropped into the penny stock range from highs almost reaching 100 euros at the end of 2007.

A number of lower profile solar industry bankruptcies had already occurred in the past year as average selling prices ("ASP") for solar products declined by as much as 75%. Nevertheless, the demise of formerly industry leader Q-Cells officially marks a changing of the guard from once dominant Western solar suppliers to large scale highly integrated companies based China such as Suntech Power (STP), Yingli Green Energy (YGE), and Trina Solar (TSL).

The simple explanation of why Q-Cells and other similar Western peers failed is costs. As ASPs for solar products fell in the past 3-4 years, higher cost structured manufacturers experienced margin compression. Although pricing at each individual crystalline vertical has varied, module ASPs which are the main end product in the value chain ranged from the high $4/watt in 2008 to below $1/watt by the end of 2011. Many solar companies that operated very profitably at the higher module ASP ranges quickly saw fortunes reverse as market pricing dropped below manufacturing costs. Through larger scale, Q-Cells was able to outlast many smaller regional rivals, but pricing declines below absolute minimum thresholds last year dealt a crippling blow.

Similar to most of the solar industry, Q-Cells lost money in 2011. However, details in the company's losses revealed a much more dire situation than China's top three module producers, Suntech Power, Yingli Green Energy, and Trina Solar. Nearly half of Q-Cells' 845.8m euro loss resulted from 398.5m euro impairment charges which should be factored out when evaluating the company's operating cost structure. Even with these non-recurring charges removed, Q-Cells posted a net margin of -43.7% on 1.023b euros in revenues.

More importantly, the company's annual gross margin was negative in stark contrast to its larger integrated Chinese peers. Because Q-Cells reports EBITDA gross margin which is different from US GAAP accounting reported by US listed Chinese solar companies, adjustments have to be made which may not be an entirely apples to apples in comparison. While it is likely the bulk of Q-Cells' 2011 depreciation/amortization expenses would be factored into gross margin, portions may be linked to operating expenses.

With an EBITDA gross profit of 33m euros and overall depreciation/amortization expenses of 97.2m euros, Q-Cells' annual gross margin, if accounted in the same method as US listed Chinese solar companies, could have been as high as -6%. In contrast, Suntech Power, Yingli Green Energy, and Trina Solar reported positive 2011 annual gross margins of 12.3%, 16.7%, and 16.2%, respectively.

Despite weighted average ASPs declining by approximately 25-35% in 2011, Q-Cells' annual average gross margin had already turned negative. With additional weighted average ASP declines of 25-35% required to reach current market prices, the company's EBITDA gross margin, essentially "cash costs" of production, would likely turn extremely negative. In other words, in the past several months market pricing has most likely dropped below Q-Cells' minimum cost threshold.

Below this point, companies would lose even more money by turning on factory lights and producing goods, which is why companies often shut down production until market pricing recovers sufficiently. Companies with stressed balance sheets unable to endure prolonged periods of shut downs have been the cases for industry bankruptcies witnessed in the past year. These dynamics, among other factors, may have contributed to Q-Cells' recent demise.

Casual observers may conclude the solar industry is not sustainable when its leading companies have failed. Q-Cells after all was not "a" but "the" leading solar cell manufacturer in the world a few short years ago. Borrowing from the dotcom bust of yesteryear, some have labeled the solar industry as a bubble. To an extent, the skeptics are right. The solar industry existed in a bubble which peaked during the past five years.

What caused this solar bubble? The short answer is subsidies. In order for the solar industry to be sustainable and economically viable in the long term, its demand must not be influenced by any subsidies. However, subsidies in any industry are not new concepts. All governments in all parts of the world have subsidized certain industries in one form or another past, present, and undoubtedly in the future. The photovoltaic solar industry may not have been able to reach the scale required to achieve grid parity thresholds so quickly without subsidies. As with all bubbles, it eventually pops and that is reflected in the brutal wave of consolidation the industry has experienced in the past year.

Q-Cells, much like prior defunct peers, is simply a remnant of this bubble. High photovoltaic feed-in-tariffs in Germany as well as other parts of Europe started entire industries - many of which may have been created only to take short term advantage of subsidized markets. Capital was cheap and easy to obtain especially when renewable energy was hyped as a replacement to surging fossil fuel prices.

Fat margins also made ROI on capital expansion so lucrative such that investments could often be fully recovered in just a year of operations. In other cases, easy access to capital, especially among the industry leaders, generated a spending frenzy on questionable investments in both unproven technologies as well as untested fledgling companies.

Most of the solar failures the industry has witnessed over the past couple of years has largely been the result of flawed business models and not the result of a flawed industry. Q-Cells, like many European and American higher cost structured peers, based business models which targeted cost reductions by a targeted date which in theory would match grid parity and thus become economically viable without subsidies. In a closed environment this was a sound strategy. However, in the real world free market, competition drove costs much lower much sooner wiping out less competitive companies almost instantly once market pricing dropped below manufacturing costs.

While the subsidies certainly allowed for many flawed business models to materialize, such as Solyndra's collapse last year, other companies such as Q-Cells were more a victim of capitalism. Many of the more distinguished names which have collapsed in the past year were able to generate profits at market ASP levels seen 5-6 quarters ago. Again, in a closed environment, module ASP levels seen a year ago were already low enough to be economically viable in many markets without subsidies if compared to grid electricity pricing. Without competition, companies with cost structures on par with Q-Cells had already reached unsubsidized sustainability in many regional markets. To this end, many of these companies had succeeded in original cost objectives.

In a capitalist free market world, everything becomes relative. China's top tier module producers like Suntech Power, Yingli Green Energy, and Trina have set the bar extremely high. Many will blame unfair practices but as US listed public companies, open books and audited financials reveals how leading Chinese brands have been able to reduce costs. It has not been through complex practices but simply due to business strategies successful in other industries - scale and integration.

Yingli Green Energy and Trina Solar are perfect examples of efficiency. Yingli Green Energy maintained a fully vertically integrated manufacturing model which eliminated a number of middlemen. Trina Solar achieved the same result with onsite co-location of key suppliers for components not manufactured internally. Extremely large scale operations at centralized locations also allowed Chinese producers to horizontally integrate and produce consumable components in house further cutting out additional middlemen. Vertical and horizontal synergies also reduced logistical challenges not only in costs but also transport time.

In contrast, Q-Cells was predominately a solar cell manufacturer and in its early years operated as a single vertical producer. Upstream silicon wafers were procured and often transported halfway across the world such as from China where LDK Solar (LDK) was once a major supplier. While the company also expanded downstream into module production, it later contracted module assembly to Chinese companies such as Hanwha Solar (HSOL). In extreme cases, module components made double round trips halfway around the world before a module's completion. Q-Cells was not the exception. US based Sunpower Corp. (SPWR) also detailed a supply chain which spanned up to 5 different countries in prior annual reports.

Quite simply, competition destroyed inefficiency. Continued cost reduction efforts by the industry's lowest cost producers, namely those in China, allowed for lower market ASPs for solar modules. Pricing declines, particularly in the past three quarters, greatly accelerated consolidation within the sector. As module ASPs dropped from an industry average of $1.50/watt in Q2 2011 to below $1.00/watt by the end of last year, production cost thresholds for the vast majority of the industry especially for manufacturers outside of China became breached.

This was likely the primary reason for the bulk of capacity shut downs and corporate bankruptcies that occurred in the second half of last year. Once market pricing dropped below the minimal production cost threshold for a producer with no signs of ever recovering back above that level, the business model for that company broke completely.

Collateral damage caused by the industry's consolidation was felt by all companies regardless of relative cost structures. In the likely event Q-Cells completely dissolves, the entire industry would have to endure its short term ramifications. While investors may have already marginalized Q-Cells as an investment based on its share price collapse in the past year, the company was still a major player in 2011. Q-Cells' output at the cell level was 783MW which was roughly 3% of the industry's installation level in 2011. Of this total 717MW was crystalline cell production which means the same volume of upstream wafer procurement as well as downstream module assembly, whether in house or outsourced, was required. In other words, a meaningful portion of the global supply chain would be impacted in the short term. For companies heavily exposed to Q-Cells, the impact may be equally terminal.

What has affected the industry most has been declines in spot market pricing for crystalline based components across all verticals. Quoted from executives among the industry's cost leaders such as Trina Solar and similarly heard from peers, pricing has been at irrational levels which did not support reinvestment. In extreme cases, quotes were even below the cost structures of the industry's lowest cost producers. With capacity reductions and corporate closures accelerating in the past 2-3 quarters, the most significant impact on the industry has been a chain reaction of inventory liquidations which has distorted industry pricing to below longer term sustainable levels.

Once again using Q-Cells as an example, the company ended 2011 with approximately $185m worth of inventory. This compares to fourth largest globally ranked module supplier Trina Solar's $250m worth of inventory in the same period. In the likely event Q-Cells cannot continue operations, its inventory would likely be liquidated into an already buyer's market to satisfy the company's creditors. Companies fatally linked with Q-Cells' demise may also negatively compound the pricing situation.

Inventory liquidation was most likely the root cause of rapid ASP degradation across all verticals which led the industry's production cost leaders such as Trina Solar and Yingli Green Energy to subsequently lower their own pricing. After all, module ASPs reported by China's top three module producers were consistently 10-20% above spot market averages throughout 2011.

Because market pricing has penetrated a large portion of the industry's remaining manufacturer's production cost thresholds, the current consolidation cycle will likely continue indefinitely and ultimately narrow the field considerably. Just a year ago Trina Solar's CEO predicted only one or two dozen companies would likely exist by 2015. The time table for this prediction may have been accelerated based on the industry's current pricing levels. Eventually, once the last remaining elements of the industry's bubble "froth" are removed, market pricing should stabilize to levels where margins for the industry's cost leaders support not only ongoing operations but also reinvestment in order to support rising global demand.

Due to much lower installed costs for solar, the industry has already reached - if not surpassed - grid parity in many key markets around the world. In cases such as Germany, feed-in-tariff rates have already dropped well below grid levels which implies a natural demand curve should dominate forward installations. Despite whatever remaining legacy solar subsidies still exists in many markets, it is critical to note that overall installed costs have dropped to levels where levelized cost of electricity ("LCOE") when computed using a solar modules guaranteed output is below grid rates in the world's current largest solar markets, including China.

The survivors of the solar bubble will ultimately capture more market share in an industry where growth should continue not based on subsidies, but a natural demand curve.

Disclosure: I am long TSL, YGE, LDK, HSOL.

Additional disclosure: No position in STP, SPWR, QCE (Germany).

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