Solar Industry And Burden Of Debt: A Q4 View

by: Robert Dydo

While operational efficiency, quality and sale channels are essential to win over the competition, there is a limit to which financial resources can take on the stress of operating under negative gross margin or selling below cash costs. The year 2011 has tested those boundaries, and not surprisingly, the most inefficient companies have succumbed and become casualties of bankruptcy. While the beginning of 2012 has the usual tendencies of mixing pessimism on one end with euphoria on the other, the ongoing deterioration of the average selling price (ASP) remains in place, having an adverse effect on gross margins. While most efficient manufacturers look for ways to reduce the cost, the industry has been made an outcast, living in the shadow of fear of insolvency.

In the last article we speculated that ASP levels are the mechanism to reduce the last remaining competition, consisting of medium- to small-capacity businesses located in Mainland China. While we suggested this to be a strategy, the length and severity of this condition is not clear and has an inherent risk to organizations that lack financial strength. Whether the hypothesis is real or the ASP drop has another cause, the financial health of the organization becomes a critical benchmark in the countdown until the business must either reach a holistic balance between ASP and costs to produce profit, or drift away into insolvency. There is very little doubt when looking into the future of solar energy, about opportunities for exponential growth. However, while this growth seems to have fewer reservations about years beyond 2020, there are more questions about survivability and staying power for the next 12 to 24 months for the majority of the companies today.

In our recent article we tested revenue-generating power and identified the top 20 earners within the industry. One of those companies, Q-Cells (OTCPK:QCLSY), became a victim of market conditions and declared bankruptcy just this month, so the risk or the concern is reasonably real for others. The solar industry is also relatively undeveloped and remains at the early stages of growth and acceptance. As such, high levels of debt and equity have been used to build capacities and promote new technologies, and with the exception of 2010, there were only a few periods of significant profitability. Those observations are visible in the debt levels of the companies on our list, and particularly in times of distress there is a confirmation that the burden of debt has deadly qualities. Yet, in the way vertical module makers differentiated from others in double-digit revenue growth, no debt structures are equal to each other, thus dismissing the mistake of generalization. The same level of error can be made when assuming that cases of operational efficiencies are supported by healthy day-to-day financial management, and that the owners of good quality balance sheets can remain financially savvy with inefficient manufacturing.

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Some companies, despite the tough circumstances, did a better job than others in managing their financial condition. In a combination of debt reduction efforts with an increase of cash, Suntech (NYSE:STP) was the best performer along with Hanwha SolarOne (HSOL). The next two were SolarWorld (OTCPK:SRWRF) and Sunpower (NASDAQ:SPWR). In this case companies increased the level of cash without adding debt. Taiwanese Motech added almost 50% in cash; however, Norwegian REC (OTCPK:RNWEY) increased its cash account by 218%. Some of the cash came from debt, but REC ended the quarter with $90M of more cash on balance between debt increase and cash increase.

In difficult times an increase in debt may suggest that a company needs to use borrowed money to manage day-to-day business. In times of growth, borrowing is generally spent on capital expenditures. GCL Poly has increased its debt levels by almost 60% by adding a whopping $1.5B to the bottom line in the second half of the year. The company had doubled in size during 2011, and it is currently the largest polysilicon producer in the world with the most efficient and largest wafer capacity, so it appears that money was well spent. GCL is also one of three businesses on the list who have managed to stay in the black for the fiscal year of 2011. Renesola (NYSE:SOL) and Jinko Solar (NYSE:JKS) are the other two. The biggest percentage change in level of debt was by the Taiwanese company Neo Solar Power, which increased its debt level by 62%, while losing 10% in cash compared to Q3. The largest percentile of debt lessening was recorded by Canadian Solar (NASDAQ:CSIQ) with a 12% reduction; however, the company had also reduced its cash almost dollar for dollar, which may suggest an expiration of maturity and not necessarily a trend in debt decrease.

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Due to low ASP, there was a lot of pressure on inventory and companies were forced to use market evaluation methods to reflect the pricing. Consequently, the drop in levels may not immediately indicate better material management or improved demand, but may be due in part to one of these, if not all of those adjustments. Almost all Chinese US-listed companies managed to decrease inventory by an average of 25%, with Hanwha and JA Solar (NASDAQ:JASO) leading the results with reductions of around 40%. Exceptions were Yingli Green Solar (NYSE:YGE) and First Solar (NASDAQ:FSLR), as both actually added to inventory during Q4.

Q4 represented a mix bag of results when it came down to operating expenses. In addition, servicing debt through interest payments showed the impact of heavy leverage when gross margins are razor thin. Since results for both periods are inundated with negative adjustments to account for all possibilities in an already-muddled fiscal year they certainly do not represent normalized conditions. Largely due to these actions market expectations have improvement built in for Q1 results. However, if bleak conditions continue and adjustments are further required those with less debt and better operating expenses are expected to last longer. Those who have higher debts may become in breach of loan covenants and guarantees based on changes in asset ratios, reducing their ability to retain good credit, losing preferential interest rate, or simply being forced cover the difference between the original collateral and current asset values.

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In summary, companies like Conergy (OTC:CEYHF), Jinko and REC appear to be cash strapped against their debts. In release of the Form 20-F, Jinko announced new debt worth RMB300M ($50M), which will prop the cash account for the time being, but it is a confirmation of this statement. From the perspective of inventory management Yingli and First Solar appeared to have issues with demand in the last quarter; however, Yingli is increasing its capacity and is expecting to beat volume results in Q1. In contrast, First Solar is liquidating capacities in Germany and shutting down production lines in Malaysia. First Solar third-party sales dried out in Q4, and this was evident in inventory. In the case of Yingli, at least for now, the inventory condition appears to be temporary.

If other parts of the business are putting pressures on First Solar, the company does not have to worry about cash coverage against its debt. For every dollar of debt, FSLR has $0.91 cents of cash. Trina Solar is a close second. It comes with great surprise that GCL Poly has worse coverage of cash for its debt than REC of Norway; however, calculated interest expense for GCL is only at 4.11%, which extends the ability of paying interest expense for GCL to 22 quarters versus REC's 9. Because GCL debt has been added only recently, there is a very good chance that interest expenses were not paid on the new portion. For illustration purposes the interest rate is calculated using the new debt and the existing interest expense. There is a strong possibility that the GCL interest rate by the next two quarters will be in the area of 6.6%, which would make yearly interest payments equal to $270M. This would reduce the ability to pay interest from cash to only 13 quarters.

Of course interest payments are only one of the things affecting the financial health of an organization. This is why quarterly coverage of interest rates is shown here as a theoretical illustration only. In reality, business needs to involve a lot more than just a capacity to pay interest.

In Q4, 18 leading companies added $1.9B in debt, while increasing cash accounts by $600M. The table also shows that in contrast, Chinese solar companies have quite average interest rates in comparison to other global companies, illustrating that preferential treatment by Chinese Banks is not seen in the balance sheet. Exceptionally low levels of interest, however, are seen among the Taiwanese as a group. One of the explanations may be related to the fact that almost all of those are financed from parent organizations at one time.

While there was great effort made in the preparation of this data, in case of any doubt please refer to the original SEC documents or official news releases for accuracy. Some of the accounting formats used by European and /or Taiwanese public companies were adjusted to make comparison possible.

Disclosure: I am long TSL, YGE.