MEMC Electronic Materials: Climbing the Wall of Worry

With the explosion of oil prices and implosion in the value of the dollar, a perfect storm is brewing for U.S.-based, export-oriented providers of alternative energy related products. MEMC Electronic Materials (WFR) fits that description nicely, though investors will have to climb a “wall of worry” to overcome some of the fears holding the stock back.

MEMC refines silicon, grows silicon ingots and slices wafers for electronics and solar applications. 80% of its revenues come from the semiconductor industry (projected 7.7% CAGR over the next 5 years) and 20% from solar applications (47-81% solar industry CAGR projections from Solarbuzz and Photon Consulting respectively). WFR’s revenues have grown at a 23% CAGR for the last five years and are projected to continue growing at that pace or better for the foreseeable future, according to its CEO Nabeel Gareeb.

While MEMC can count on steadily growing profits from its position as one of the top providers of silicon wafers for the semiconductor industry, growth is fueled by the solar sector which is expected to grow to dominate its revenue and profits over the next decade. MEMC has four main outlets for its silicon and wafers in the solar industry. In the last two years MEMC has signed long-term (typically 10 year) take-or-pay contracts with Gintech (Taiwan), SunTech Power (STP) (China) and Conergy (Germany) totaling over $15B. These contracts give MEMC excellent revenue visibility and guaranteed growth at very profitable pricing.

All three companies provided MEMC with up-front cash and stock warrants to secure their silicon supply. That type of pricing power is only strengthened when one considers the contracts were signed at a time when the dollar was significantly stronger than it is now. MEMC’s cost competitiveness has only strengthened since these contracts were signed. The fourth outlet for MEMC is the spot market for silicon which has seen prices explode from under $100/Kg to over $400/Kg last quarter (vs. typical contract prices of below $100/Kg). MEMC sells into the spot market, though it is increasingly shifting its capacity to serve long term contracts.

The case for MEMC seems overwhelming. Their gross margins are excellent (52% in the most recent quarter, with the solar and spot silicon margins being significantly higher still), operating margins are an impressive 43%. Operating cash flow is 39% of sales. No other solar-related company can boast those kinds of numbers (not even the much favored First Solar). In aggregate these numbers will improve as MEMC shifts revenues from being 80/20 semiconductor to a much higher solar mix.

The case for MEMC is further strengthened when one considers the barriers to competition it has erected. Refining electronic or solar grade silicon is a capital-intensive, complicated and even dangerous business. Two processes are employed in the industry. The Siemens process is the more widely used and readily licensable process. Literally dozens of players, especially in China, are scrambling to erect refineries using the Siemens process to satisfy demand for silicon that is expected to grow at a rapid rate for many years to come. The second process used employs a fluidized bed reactor [FBR] to provide a more continuous process for producing silicon. MEMC has the longest experience and greatest success with FBR of any company in the industry.

While they are very tight-lipped about the advantage that FBR gives them, indications are that FBR, while finicky to control, consumes a fraction of the energy and materials of the Siemens process. MEMC knows the differences first-hand as they operate both processes (FBR is the process they are spending capital on for their expansion). FBR is a key element in MEMC’s extraordinary margins. MEMC’s competitive position is further enhanced by the fact that it produces its own feedstock gases required for both the FBR and Siemens process. MEMC’s CEO has speculated that even if the China-based silicon refiners are successful in perfecting the Siemens process (which itself is complicated albeit not as challenging to control as the FBR process), those new players will quickly run into difficulty securing the raw materials required to feed their new plants.

According to management, the higher purity of MEMC silicon relative to its other solar competitors leads to higher solar conversion efficiency (more on that later). Often MEMC’s virgin silicon is used by MEMC’s customers to mix with less-pure silicon to stretch supplies. This puts MEMC in the enviable position of being the quality leader in addition to being the lowest cost (though not price) provider. Comparisons to Intel (INTC) in the 1990s are not unwarranted. Intel was the premium provider of semiconductor devices, with the lowest costs (owing to scale) serving a market with a long term growth rate not quite as high as solar’s is today. MEMC has a 5 year track record of growth, excellent visibility to sustained growth in the future in one of the fastest growing industries anywhere, fantastic financial performance, an impeccable balance sheet and sustainable competitive advantage.

With so much going for it, why is MEMC trading at a paltry PE of 15 times forward earnings and 30% off its highs of December? The case against MEMC is composed of a half-dozen or so fears. Each deserves careful analysis, but instead tends to elicit emotional reaction (and wild volatility in MEMC’s stock price). When the dust settles, reality should win out. So does the analysis of the risks justify the current stock price? The main risk factors are:

(1) Operational execution problems

MEMC has missed their earnings estimates twice in the last year (though they were near misses, off 1.2% from estimates last quarter). Both times were attributable to temporary factory shutdowns due to accidents. The sensitive nature of the refining process makes even a temporary power loss a catastrophic event resulting in days or weeks of lost production. This vulnerability is exacerbated by MEMC’s very lean production processes and practices which lead to very little inventory being available to cushion the blow of any production loss. With just over 1 week of inventory of all kinds on hand, MEMC is very cash efficient, but not resilient in the face of any unexpected event in production.

In the last conference call (which came following one of these earnings misses) the CEO was asked several times about the extremely lean inventory position MEMC maintains. Hopefully the message sunk in that while it is nice to save a few dollars in inventory carrying costs, it comes at the price of literally billions of dollars in market cap owning to the uncertainty that results in MEMC’s ability to make its earnings forecasts. An extra week of inventory would cost MEMC around $15M in shifting cash to inventory on the balance sheet, but would be a welcomed insurance policy against future production glitches (MEMC’s customers would probably appreciate it as well). It will be interesting to see if in the July earnings report MEMC takes some steps in this regard to shore up investor confidence. This will be a rare case where an increase in inventory on the balance sheet should be seen as a strong positive.

(2) The potential for a silicon glut

As stated above, dozens of companies such as LDK (LDK) and Hoku Scientific (HOKU) are scrambling to build plants to satisfy the exploding demand for solar-grade silicon. There are natural fears that this will result in over-capacity. There are two mitigating factors. The first is that many of the announced plans for new plants are likely to fail due to an inability to raise the required capital, failure to solve the technical hurdles to achieve cost-effective mass production or failure to secure the raw materials (which are also in short supply) required to feed the new plants.

Already some companies (e.g. Trina Solar (TSL)) have shelved their plans to build silicon refining capability. The second mitigating factor is that consumption of silicon is projected to increase at a 39% CAGR through 2012 (source: Renewable Energy Corporation). That requires a fivefold increase in supply from 2007 to 2012 to satisfy demand growth. If the industry achieves that, MEMC will still be in a favorable position owing to its lower costs, superior product quality and strong financial position.

While China (where most of these new silicon plants are going up) has an inherent advantage for labor-intensive products, silicon and silicon wafers are not labor intensive. In 2005 it was argued that by 2008 there will be a silicon glut. Now the argument is made that 2010 or 2012 may see a silicon glut. With solar expanding so fast, we can expect continuous fears of shortage or glut as the market responds to massive growth.

With a range of growth rates projected to be between 47% and 81% for solar modules, any silicon price decline will likely stimulate demand to come closer to the 81% figure. MEMC has insulated itself against these swings by securing 10-year take-or-pay contracts for the bulk of its production. While MEMC may see its occasional sales of silicon on the spot market decline in the event of a silicon glut, its core business is secure with 25% annual growth practically locked in for the better part of 10 years to come.

(3) Substitution of metallurgical silicon for refined silicon

Related to fears of silicon glut are fears of solar module manufacturers substituting metallurgical silicon for refined silicon. Metallurgical silicon (a much less pure form of silicon derived from a continuous purification process) is much less expensive than refined silicon.

However it has several drawbacks, mainly lower efficiency and a shorter product life. Conversion efficiency is a critical metric for solar panels. While a panel may cost $4 per watt, the end customer may pay an additional $4 for the rest of the installation. If a panel is 15% less efficient because it uses cheaper metallurgical grade silicon, then the non-silicon cost of the installation will increase by more than 17% (because more panels must be installed to produce the same amount of electricity). Decreasing the cost of the silicon, if it results in lower efficiency, could lead to an increase in the cost of the complete solution.

Some real numbers can help illustrate the point. In Trina Solar’s latest earnings call, they stated that their silicon cost is $1.75 per watt to produce a solar module. The installed cost per watt for a residential PV system is approximately $7.50 per watt. If metallurgical silicon is half the cost of refined silicon (a claim one company has made), but results in a 15% lower efficiency module, then the value chain has saved $0.88 on the module, but must increase the balance of system costs by $1.01 to make up for the reduced efficiency. In addition, the impurities of the metallurgical grade silicon cut the life of the module from 25 years to as little as 10 years. If the efficiency loss can be reduced to 10% or the cost can be reduced to much less than half that of refined silicon, then metallurgical silicon may have a role to play, but only if customers don’t mind seeing their warranties reduced from 25 years to 10 or 15 years.

Nevertheless, MEMC tumbled when Q-Cells (not a customer of MEMC’s) announced that they will be using some metallurgical silicon in some of their modules. This area bares watching, but is not a significant immediate threat to MEMC.

(4) Uncertainty in government incentives

Anyone familiar with the solar energy industry is familiar with the fickle approach Congress has taken to tax incentives for alternative energy. Federal incentives are scheduled to end after this year. Extending them has been a political football as both sides claim to support alternative energy, but the bills so far presented are weighed down with many provisions having nothing to do with alternative energy and which offend one side or the other. Likewise in Europe the generous subsidies provided to solar are on a path for reduction. Solar stocks (including MEMC) tumbled as speculation rose that subsidies in Germany might be cut by 30%.

The eventual outcome seems to be a much tamer 10% cut. This past week, similar rumors were spread that Spain was going to cut subsidies by more than was previously expected. The ultimate outcome in Spain is yet to be determined. Fortunately, with rising retail electricity prices falling solar costs, price parity without incentives has already happened in many areas and will be the norm across most of the world by 2012.

The likelihood of a complete end to U.S. solar and wind subsidies starting in January 2009 is already priced into MEMC’s stock. Any new government action is likely to be a positive for MEMC.

(5) Competition from thin-film based solar

Companies like First Solar (FSLR), Energy Conversion Devices (ENER) and soon SunTech Power (STP) are pursuing thin-film based solar modules and building integrated photovoltaics [BIPV]. These solutions don’t use MEMC wafers (the silicon they may use in making the films is not a meaningful market opportunity for MEMC).

The question is how fast will thin film based PV grow, and will it come to supplant polycrystalline-based PV. Once again the question here revolves around efficiency. The best thin film PV today achieves approximately 10% efficiency at a cost of around $2.50 per watt. The best silicon PV achieves 22% efficiency at around $4 per watt. Both technologies are seeing improved efficiency and lowered costs, however it is unlikely that thin film can make up the efficiency difference in the foreseeable future (the best thin film PV in a lab setting achieved 19% efficiency).

Because the efficiency leverages the balance of system costs as described above, thin film is most applicable in centralized PV plants or in BIPV applications where the balance of system costs are much lower or absorbed by other functions. So long as silicon-based PV maintains a significant efficiency advantage over thin film, MEMC will thrive. If you own a home and can make a 25% ROI installing thin film PV or a 20% ROI installing silicon-based PV, but you can install twice as much capacity with the 20% ROI investment (because your roof area is of fixed size), you are better off with the larger investment at the lower return assuming you have accessible capital.

Longer term, several improved thin film approaches are in development. One direction is to dramatically lower costs without significantly increasing efficiency. Startups NanoSolar and Konarka are applying films to plastic substrates to achieve claimed costs below $1 per watt. Thin film approaches will continue to appeal to centralized PV installations where space and efficiency are less important than per-watt cost.

For distributed solar (on rooftops), higher efficiency remains most important because of limitations on the physical area of the deployment. While thin film approaches are being researched for these applications, many thin film approaches involve applying thin films to bulk silicon substrates. Each film layer is designed to convert electricity from a particular segment of the spectrum which the bulk silicon does not utilize efficiently.

These approaches would continue to be served by MEMC as the provider of the bulk substrate silicon. Intel’s spinout Spectrawatt will be one to watch as speculation is that their technology is based on thin films layered on silicon wafers.

Any investor in MEMC can expect the occasional panic as announcements come from various thin film players, but in reality thin film addresses a different segment of the market from wafer-based PV modules.

(6) Margin sustainability

A common theme in MEMC’s conference calls is whether its 50-55% gross margins can be sustained in the face of contracted price declines in the solar segment. MEMC has several opportunities to expand margins even as their contracted ASPs decline. In the semiconductor market, MEMC’s volumes are steadily shifting toward higher margin 300mm wafers and wafers with advanced features to improve device performance and yield. As MEMC’s overall volumes shift from being 20% solar to a much higher percentage being solar, gross margins will expand.

Aside from spot silicon sales, in the solar market MEMC sells wafers on a cost per watt basis. This means MEMC keeps all the benefit it derives from optimizing the ingot growth and wafer slicing operation. Today MEMC outsources wafer slicing for the solar market. Margins will expand as this function is brought in house (which is expected to begin in 2009). MEMC’s track record is strong in the area of continuous incremental margin improvement.

(7) Uncertain prospects for the semiconductor market

The slow growth of the semiconductor market has been a drag on MEMC recently. It appears, however, that the semiconductor market is near the bottom of its cycle and the accelerating solar market has more than made up for the general softness of the semiconductor market.

For the short-term trader, these risk factors make MEMC attractive as news on any of these fronts tends to move the stock price disproportionately making option risk premiums large and making possible swing trades. For the long-term investor these risk factors appear to be a “wall of worry” which will have to be climbed. MEMC’s management has shown good transparency in addressing these risk areas.

With its recent stock price hitting the low $60s, now may be a good time to move in to WFR and start climbing. There are several possible triggers for rapid appreciation in MEMC’s stock price going forward:

• July earnings report - The market is looking for confirmation the MEMC’s Q1 production snag has been corrected. A modest build up of inventory will also be hoped for to guard against future earnings misses. The current stock price doesn’t seem to anticipate much if any upside to the estimates, however several factors could make Q1 exceptional:o Faster than expected capacity expansion – management has given cautious guidance that capacity expansion is ahead of its original schedule.o Resumption of growth in the semiconductor sector – results and guidance for the semiconductor sector are hard to predict.
• A fourth long-term contract - MEMC’s CEO has indicated that capacity exists for a fourth long term solar contract probably in the $2-3B range (spread over 10 years). This could be a catalyst for the stock but could also signal that the next shoe to drop is a further capacity expansion facilitating more growth. MEMC’s great return on invested capital and strong balance sheet make it all but certain that growth can be sustained without resorting to any dilutive actions. 
• Stock buyback - So far MEMC has not been very creative with its stock buyback plan. Given the stocks’ volatility, liquidity and large option premiums MEMC could be using its $500M stock buyback program to collect millions of dollars of premiums each quarter while putting a floor under the stock. Instead they seem to be executing a fairly pedestrian plan. With the cash being generated by the business and strong balance sheet, investors can expect another buyback program in the not too distant future. The CEO has not indicated much interest in acquisitions as he recognizes that there aren’t many companies in the industry selling at bargain prices as compared to what it would cost for MEMC to build the capability from scratch. MEMC’s financial strength could open the door for them to take more radical steps however.

When considering the risks to MEMC, it is perhaps helpful to keep in mind that at current growth rates the solar industry will be larger than the entire semiconductor industry within 10-15 years. Though the solar industry generated over $20-30B in revenue last year, it still generated less than 0.1% of world electricity demand (according to Photon Consulting). Solar is nowhere near its limits for growth and MEMC appears well positioned to ride that growth for a long time to come.

Disclosure: Author holds long positions in WFR and STP

Comments

[Cygnusx3]

Just a short note of thanks for a fascinating prospective of the solar industry overall and WFR in particular. Since you hold STP, I would hope you will publish an article about that issue as well.

[golfgator65]

Extremely knowledgable article on WFR. I've owned the stock for about a year and have read many articles. You clearly nailed the pros & cons without overly hyping the stock. I personally believe the stock is currently very undervalued, but there recently seems to be a periodic "fear" that a new technology will make WFR solar products obsolete. Your article gives solid reasons why this is not likely to happen. Great article, well done!

[fertang]

Exceptional article. Comprehensive highly informed and objective.

[Paul Price]

There was a good article about WFR in Forbes a while back. They made the point the WFR was extracting onerous terms from their customers 'because they could" due to supply demand imbalance.

When supply is not so tight these same customers may be very happy to drop WFR for other vendors after being goughed repeatedly.

Vendor - Customer relations are not very happy.

[aquaculture]

Well written. An article we've been waiting for, since it adresses the future of the entire solar sector. Perhaps it even deserves a grander title.

Worry number 8 might be:
Internet traffic statistics suggest investors are increasingly aware of the Amendola patent:
wipo.int/pctdb/en/wo.j...
Its just that nobody had thought of the fact that silica also exists as sio3- ion in the form of waterglass. Filter, run through ion exchange column to catch e.g. borates with functional groups, end up with ULTRAPURE SILICA, reduce in clean carbothermic arc furnace with ultrapure carbon and bingo: 6N solargrade silicon for about $7/kg.
I thought about this patent quite a bit, even run it through Mathematica, but see no theoretical reason for it not to work.
RSI will only make it to 1000 mt this year. But it anticipates completing the Alabama plant in 2009 (24000 mt/year) while simultaneously opening plants in Europe and China? We'll have to wait n see.
Please note: SILICA, the most abundant of all minerals, IS THE STARTING POINT OF ALL SILICON.

Then there are the 4N, 5N, 6N UMG-si efforts, which to me also represent intangible assets, simply because of the Photon projections you mentioned.
CSIQ's e-panel (100% UMG from TIM) has shown no measurable degradation over a long period now and has been well received in the market place. Even in Germany.(Germans can be very critical!)
Albeit at a 15 % discount to offset some installation costs, which are way too high anyway: a union conspiracy.
CSIQ was a bit of a pop-star at the recent intersolar in Munich because Solarvalue AG is going the same UMG-si route but bought a complete silicon factory in Slovenia.
Which brings up another interesting point: producing UMG-si at a plant and selling it to panel makers is not the best EROI in an optimized silica-to-solar-cell process, so we can expect a lot more of this sort of complete vertical integration. (M&A's?) Who knows, the Chinese restaurants in Quebec might become very busy, he he.

Solar 2008 is much of a transition year and few can seem to find a direction. Mr. Peng is publicly polyplant/LDK and privately AMAT/Best solar thin film. Acrobatic thinking.
FSLR is a tellurium casino, cq. haz. waste disposal.
CIGS is another TERRIBLE idea: the Indium is much better used in LED lighting: saves 300 coal-fired powerplants to begin with. Meanwhile Aixtron is getting hammered on the stockmarket. What a world!
There will be thin film in BIPV applications.

Poly spot prices last week: >$500! contracts.
Of one thing i'm sure: the solar sector is in a paradigm change and the current (expensive poly = government subsidies) status quo equation will disappear at some point into the future.
My own instincts tell me the electr. and solar grade silicon sectors will divorce. Not the best solar technology will win but whoever can ramp up very fast, with the least capital expenditures.
(disclosure: long CSIQ)

[Robert Odle]

Based on the concept that metallurgical grade silicon (MG Silicon) lowers costs while reducing efficiency, it seems that there would be an optimum mix of solar grade silicon mixed with MG Silicon that would provide the optimum value for the consumer. In a broader perspective, the impurities in MG Silicon can be lowered with additional processing and cost. Again, there should be an optimum amount of refining that maximizes value to the consumer.

[LearningCurve]

Excellent. Thank you, Tobind Ferrand, thank you all.

[aquaculture]

Clarification: Quebec has a power and raw materials advantage.

aqua

[July]

I could not agree with you more about your comments on MEMC. Thanks for your wonderful work.