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I have recently commented in some of my previous articles that solar stocks have stopped responding to bad news, which might signal a bottom (5 Excellent Quick Trades Until May 17). I have also commented that, in case of a market swoon like the one that might be expected in May or June of 2012, heavily shorted stocks like solar might actually bounce back as portfolio managers unwind their pair trades (Why Heavily Shorted Stocks Might Rise In A Market Swoon).

In this article, I would like to argue there are also fundamental reasons that might give rise to a solar rally. I will concentrate on First Solar (FSLR) to make my argument. The reason is, First Solar is still the leader in the solar sector and it is not subject to some uncertainties that come with being located in China.

The main bear argument against solar stocks is that the sector is not viable because the demand is not there and the prices are collapsing. It is important to separate the physical demand and the price components though. Many of the solar companies have actually almost doubled their revenues since the financial crisis, despite declining prices. As a result, it is fairly reasonable to deduce that physical demand (how much solar panel has been sold) has probably more than quadrupled. Investors should conclude that this is a remarkable performance, since solar projects are usually very large and dependent on long-term financing. In an environment where financing was scarce, to accomplish such growth is exceptional.

So why are the prices falling? The main reason is Chinese overinvestment. China has encouraged investment in the solar sector to achieve energy independence. Solar sector also used to be highly profitable so investors did not object to the overinvestment. What has happened in 2011 is, the sector has paid the price for the incompetent investment policies of the Chinese. Of course, the Chinese situation cannot be changed by the investors. However, there is still a bullish case to be made for solar stocks.

The gist of the matter in the solar sector is that there is a good amount of demand for solar panels, in spite of an inhospitable economic environment. However, the prices keep decreasing due to oversupply. If the prices were to moderate a little, the solar stocks would be great buys. The moderation in solar prices at least seem to be in the cards, however, as production cuts emerge. I will use the below SA news feed to summarize:

"May 4th' 2012 First Solar (FSLR -6.3%, previous) isn't the only solar industry player idling capacity. 90% of Chinese polysilicon vendors have suspended operations, and "a large fraction" of local solar firms shut down production in Q1 in the face of utilization rates that were often below 50%. This sure looks like the shakeout many have been predicting. Is it just in its early stages, or is a bottom being created?"

Let's get back to the special case of First Solar. This is a company, in spite of the highly negative environment, which still did not post a substantial loss in Q1 2012. It has earned an astounding $7,82 per share in 2010, when pricing for solar panels were at more reasonable levels. It trades at an astoundingly low 2,6X EV/EBITDA multiple even as it has doubled its revenues since the financial crisis. For investors more used to the P/E ratio, EV/EBITDA is a metric that is used to value companies who carry substantial debt or whose net income is very volatile due to the specifics of the sector. The EV in the ratio is found by adding the net debt to the market cap. EBITDA is roughly equivalent to the operating cash flow. An 6X EBITDA multiple is perceived as a great value in the US market. Therefore an EV/EBITDA multiple of 2,6X is an incredible value.

Although EV/EBITDA is more appropriate for solar stocks, I should probably make an analysis on the P/E basis also. My assumption is that if the solar prices were to moderate and go back up to more normal levels, FSLR would easily earn $5 per share in that environment. This assumption is based on the company's performance in the past years since the financial crisis, when solar panel pricing were more reasonable. As of this writing, FSLR trades at around $17. Based on that $5 estimate, investors would be buying the company, which has doubled its revenues even in a harsh financing environment, at roughly 3,4X P/E. Hence the title, "FSLR did not miss anything". If anything, the company has survived one of the harshest environments for its sector and its profitability is poised to rebound aggressively as solar panel prices moderate.

I should add that although FSLR is the best quality stock in the sector, many of the Chinese solar panel manufacturers will also benefit from moderating solar panel prices. The valuation of these Chinese solar stocks are also quite low. Some of these solar stocks are also quite leveraged (they carry a lot of debt relative to their assets) and their stock prices might benefit even more from an improved environment due to that leverage. I would suggest LDK Solar (LDK) for investors who want to make a more speculative trade on solar.

The solar sector is poised for a bounce because of both the change in investor sentiment and fundamentals. The sector does not crash with bad news, which means investor sentiment has turned around and value investors have bought up. Investors should of course take note of the situation in Europe, as Germany is the largest consumer of solar panels. Aside from that, if the solar panel prices moderate as expected due to the cut in production capacities, solar stocks will enjoy a double boost as both the valuation multiples expand and the earnings skyrocket.

As a separate disclosure, I have received some private messages in response to some of my previous articles asking for more specific trading advice. I am hesitant to do that because I am not a RIA in the US. A much more efficient way for investors would be to use the "Follow" feature on SA for investors who find that my trading suggestions are of good quality. I try to write posts about almost all of the trading opportunities that I can come up with anyway. As a result, there wouldn't be much to gain from more specific advising structures.

Source: This Solar Stock Didn't 'Miss' Anything