Will Some Solar Companies Face a Cash Crunch?

Note: This article was provided to subscribers of Envoy Global Research on June 12, 2008.

Introduction

This post is devoted to some thoughts on companies in the solar industry, particularly the Chinese polysilicon-based solar module manufacturers. The basic issue I address here is the risk for a serious cash crunch at some of these module manufacturers given their working capital deficits and their capital expenditure requirements.

Moreover, despite seemingly positive accounting earnings reports from many of these companies, a more careful perusal of these companies balance sheets raises serious questions as to the viability of their businesses, given the continued cash outflows. Importantly, this post does not address thin-film solar manufacturers, and my basic points do not apply to these businesses given the different economics of the thin-film segment of the solar panel industry.

Accounting Operating Metrics Are Misleading

Wall Street’s propensity to value Chinese solar companies off of accounting earnings, MW produced, and other non-cash metrics, completely obfuscates the significant cash-flow problems that many of these companies currently face. The cash-flow issues are caused by significant working capital needs, and it’s hard to imagine how the working capital situation can be improved any time soon, even in the event that polysilicon prices ease. There is simply too much competition in the industry and therefore suppliers, as well as customers, will continue to squeeze these companies on payment terms and cycles.

In the meantime, these companies are only able to keep their doors open due to a continued influx of cash in the form of loans, dilutive equity offerings, and other financial vehicles that Wall Street investment banks arrange. At issue, though, is how these companies would fare, should financing become more difficult. The businesses continue to burn thru so much cash, that it seems very likely that without financing many of these companies would go bankrupt very quickly.

Additionally, since few investors are paying attention to cash-flow, and most reports on these companies focus on accounting earnings and sales, there is a very strong incentive on the part of these companies to engage in questionable sales practices and revenue recognition policies (Note: The evidence for this is somewhat speculative, but is based on countless past examples, in other industries, of major working capital deficiencies signaling suspicious sales activity, such as “channel stuffing” and the like – see below for some interesting comments in SOLF’s 20-F filing).

The Evidence: Risk Statements in SEC Filings

Before getting to specific financial evidence, I’ll address a basic question: Why don’t these companies make money (cash, that is)?

Well, it’s quite simple. They have significant working capital deficiencies that are, and cannot be remedied any time soon, even in the event that polysilicon prices ease.

Here’s how speculative favorite Canadian Solar (CSIQ) explains the situation in the company’s latest 20-F (Note: CSIQ’s situation, is by no means unique, and is shared by nearly every polysilicon based module manufacturer. I have chosen to focus more specifically on CSIQ since it is a company I am more familiar with and additionally it is one of only a handful of companies that has already filed a complete 20-F):

Advance payments to our polysilicon and silicon wafer suppliers and credit term sales offered to some of our customers expose us to the credit risks of such suppliers and customers and may increase our costs and expenses, which could in turn have a material adverse effect on our liquidity. Under existing supply contracts with many of our multi-year silicon wafer suppliers, and consistent with industry practice, we make advance payments to our suppliers prior to the scheduled delivery dates for silicon wafer supplies. In many such cases, the advance payments are made in the absence of receiving collateral for such payments. Moreover, we offer some of our customers short term and/or medium term credit sales based on our relationship with them and market conditions, also in the absence of receiving collateral. As a result, our claim for such payments or sales credit would rank as unsecured claims, which would expose us to the credit risks of our suppliers and/or customers in the event of their insolvency or bankruptcy. Accordingly, any of the above scenarios may have a material adverse effect on our financial condition, results of operations and liquidity.

And this from Yingli (YGE):

Historically, we required many of our customers to make an advance payment of a certain percentage of their orders, a business practice that helped us to manage our accounts receivable, prepay our suppliers and reduce the amount of funds that we needed to finance our working capital requirements. However, this practice of requiring our customers to make advance payments has diminished, which in turn has increased our need to obtain additional short-term borrowings to fund our current cash requirements. In 2007, a small portion of our revenue was derived from sales that required advance payments from our customers. Currently, a significant portion of our revenue is derived from credits sales to our customers, generally with payments due within two to five months. In addition, other customers now pay us through letters of credit, which typically take 30 to 90 days to process for us to be paid. As a result, the general decrease in the use of cash advance payments has negatively impacted our short-term liquidity and, coupled with increased sales to a small number of major customers, exposed us to additional and more concentrated credit risk since a significant portion of our outstanding accounts receivable is derived from sales to a limited number of customers.

Another interesting quote, relating to the veracity of sales reported in earnings reports and collectiability of receivables, comes from SolarFun’s F-1 filing:

With certain significant customers, we enter into framework agreements that set forth our customers’ purchase goals and the general conditions under which our sales are to be made. But such agreements are only binding to the extent a purchase order for a specific amount of our products is issued and certain sales terms may be adjusted from time to time. For example, we entered into a framework agreement with Social Capital S.L. under which it agreed to purchase 84 MW of PV modules in total from 2007 to 2008. However, since we could not reach an agreement with Social Capital S.L. on actual sales terms, Social Capital S.L. has not made any purchase order of our PV modules and it is unlikely that it will purchase our PV modules in the foreseeable future. In addition, we have in the past had disagreements with our customers relating to the volumes, delivery schedules and pricing terms contained in such framework contracts that have required us to renegotiate these contracts. However, renegotiation of our framework contracts may not always be in our best interests and disagreements on terms could escalate into formal disputes that could cause us to experience order cancellations or harm our reputation.

The Evidence: The Financials

While CSIQ reported a huge earnings jump in Q1 2008 of $0.61 per share, the company, in fact, lost a significant amount of money and the earnings number is a complete mirage for significant cash-flow problems. If you compare the company’s balance sheet in Q1 to the balance sheet in the 20-F, the cash-flow issue is quite salient.

Specifically, as of 12/31/2007, CSIQ had approximately $38 million in cash, $59 million in receivables, and $71 million inventories. On the liability side, the company had $40 million in short-term borrowings, $8 million in payables, $75 million in convertibles, and $18 million in long-term debt.

On 3/31/2008, though, after a supposed record earnings quarter, CSIQ reported the following:

$32 million in cash, $119 million in receivables, and $81 million inventories. On the liability side, the company had $71 million in short-term borrowings, $17.5 million in payables, $75 million in convertibles, and $20 million in long-term debt.

Basically, in Q1, CSIQ had approximately a $60 million cash deficit (it’s difficult to get an exact number here since the company doesn’t release quarterly cash-flow statements) because of uncollected receivables. The company financed that huge loss via an additional $30 million or so in debt, and some non-strategic supplier loans (e.g. “accounts payable loans”). Even with all the financing, the company still managed to burn thru cash.

In case, this analysis sounds too shocking, perhaps it’s simpler to just point out that in CSIQ’s 20-F for fiscal year 2007, the company reported a mere $300K loss, or $0.01 per share, on an accounting basis. However, the cash-flow statement in the 20-F shows quite clearly that the company actually lost $80 million in 2007, due to accounts receivable issues and advance payments.

But, CSIQ is not alone. Industry heavyweight Suntech Power (STP) supposedly had earnings of $170 million, or $1 per share in 2007. However, actual cash-flow shows a slightly different story. In fact, STP lost $9 million in cash from operating activities in 2007.

And the list goes on: YingLi (YGE) lost over $300 million from operating activities in 2007, despite claiming a $52 million accounting earnings gain.

Conclusion

In conclusion, as is spelled out in the risk portions of polysilicon-based PV suppliers, and as is evident from annual and quarterly financials, working capital cash-flow deficiencies are a serious financial drain on many of these companies. As such, valuing these companies off of earnings is misleading and vastly overstates the underlying economic value of the companies.

Moreover, considering the tremendous amount of capital expenditures still needed by these companies to ramp up production to meet demand, it should be obvious that polysilicon-based suppliers are starving for cash. However, since the industry is currently oversupplied and suppliers have little differentiation, it seems clear that there is a significant risk that these companies could face a cash crunch should investors grow tired of financing these companies.

Finally, since these companies recognize that Wall Street rarely looks into actual cash-flow, they have every incentive to book unprofitable and questionable revenues, in an effort to produce strong top-line and accounting-earnings growth. Nevertheless, when certain contracts are called into question by customers, and other questionable revenue recognition policies are addressed, companies may need to restate earnings and erase past profits.

Disclosure: none

Comments

[Learning Curve]

This is critically important information and perspective. Thanks.

[rd4sndk]

You've done a great hack job on the solar sector, but let's look at what the balance sheet really says. For CSIQ, inventory ramped to $81 mm from $71 mm. That's a 14% increase q-o-q. No company in their right mind will increase inventory when sales are not being made. Secondly, 30 and 90 day terms are typical for all businesses especially for service oriented business which have to rely on MFG credit worthiness to fund inventory builds. Solar companies limit their exposure to even heavier marketing cost by relying on a small number of integrators. They also limit labor cost by relying on integrators as well. However, nonvertical industries do share marketing and installation cost by providing consignment inventory to their custormers. Further, booking this cost is done only when the sales are made not when the consignment is delivered. The 30 to 90 day terms are used to help cash limited integrators.

Your post is nothing more than a cover to short these companies. The important matrix in the solar sector is visibility of sales. Companies like ELSR and CSIQ with 2 years of sales backlog is not a company going out of business any time soon. On the contrary, its apparent that with increasing volume, panel efficiency and growing awareness I for the life of me don't see this trend ending for at least 5 years-- with each year bringing surprised upward revision of capacity and revenue.

Great hack job though!!

[jemor1961]

I agree this "analysis" is not worth the space it occupies. A "use" of cash does not represent a "loss" not recorded for accounting purposes. Get an analyst who has some financial training.

[Envoy Global Research]

I am not questioning whether sales are being made, nor whether solar growth will continue (which it obviously will). The issue is: What are the terms of these sales?

Are the companies just shipping tons of product without actually receiving the cash? When are they getting paid? How will they continue to finance the cash drain that occurs because of prepayment to suppliers and longer credit cycles to customers?

As far as accounting: If you don't have cash in your bank account, you are out of business. That's the only thing you need to know. The only way to get cash is to actually make money or to borrow the money.

To date, may solar companies have been quite successful in borrowing money or selling stock to replenish their cash reserves. It will be interesting to see how successful they are if capital markets dry up.

Best of luck.

[rana]

let's start with the risk of not being able to raise money. with this i totaly agree. capital markets are problematic right now and we don't know when things will get better. of course there is the risk of the companies in the sector but this is another issue.
now let's check the statement "And the list goes on: YingLi (YGE) lost over $300 million from operating activities in 2007, despite claiming a $52 million accounting earnings gain."
this statement is completly WRONG. cash flow isn't a profit and loss statemnet. if we were to use this method we would have been looking at things the wrong way. a company can have a profit even if the cash flow is negative. this is an accounting issue.
the proper way to say is: YGE used 300m$ (assuming this number is the correct one) in it's operating activities. it didn't lose, it used (or burned or whatever term you choose from the accounting lingo).
regarding the future needs for investing activities, there's no doubt money will need to be raised if growth will stay at the current levels.
regarding the accuracy of the statements i can't comment.
regarding the type of contracts there is a problem as the customers can turn down the order as it's take or pay contracts. so for a given fine (or no fine at all if the contracts are not take or pay, but subject to price nagotiations) they can turn it down.
so no doubt we have lot of risks in the sector (many of them aren't even mentioned here), but what does it all say?
for new industries, over the centuries, we can see the same pattern - new companies burn money in the early stages. they give good credir terms to the customers, they build higher inventories, they buy lots of equipment and employ more workers... at some stage things turn and if they don't some of the companies go bust. still, the fact that the cash flow is negative doesn't mean much here. if we have a retailer that has big cash deficits it's a big red sign, but in this sector it's natural and thinking that a company can be in this industry for a short time and have great positive cash flows (operating or free) is kind of misunderstanding the issue.
so the bottom line is simple - there are risks, because of these risks there is a possibilty for high rewards, if someone checks the reports of a company and thinks that the risk is too high than stay out. but do it for the right reasons. if you think the credit crunch will get worst than we must stay away from some of the companies since they might not be able to raise money or the dilution will be too big.

[ac_48]

To Envoy Global,

As you said " Are the companies just shipping tons of product without actually receiving the cash? When are they getting paid? How will they continue to finance the cash drain that occurs because of prepayment to suppliers and longer credit cycles to customers?"

Do you have any evidence that they are not getting paid from their sales? They would go under if the market demand starts to shrink and overspply occurs. But I don't see that is happening yet. You said the market is oversupplied right now, how is that so?

[ac_48]

These companies you mentioned could just hold back their capacity expansion, and just sell what they can produce to keep the product price steady, or even to go up if demand increases. Then all the potential cash flow problem as you mentioned will go away. Instead, they are doing the opposite, because they believe by increaing the output, the price will go down towards grid parity, which will in turn drive the demand up tremendously. I think they are doing the smart thing, do you think so?

[james shaw]

The main customers for those solar companies are in European countries such as Germany, Spain, etc.

These countries have the long reputation of doing good business practices. I don't think that they will refuse to pay the deliveries.

It is normal to pay in 30-90 days. Don't let those to scare or mislead small investors.

The publish of this article at this time is a good indication that the solar stock prices are approaching bottom.

The same type of article is also appear on Yahoo by Motley Fool last week.

Solar sector will keep growing for at least the next few decades. We expect new technology will be developed, cost will be bringing down, efficiency will increase. Wider application will be expected.

Solar energy is a good, clean way to solve long term energy shortage problem. As SUN provide huge amount of energy to the earth free.

If we only use very small portion of it, we can completely get rid of oil. Oil will be used up sooner or later. Solar energy will not.

Chinese solar companies have the cost advantage compared with US companies. Some companies also do have their own technology.

I will continue investing in the future of our clean energy industry no matter how the noise bashes the industry poineers.

[Global Warming Examiner]

These companies are making profits but sucking up cash. That would be expected as they are growing very rapidly. They need tremendous amounts of money to pay for new equipment plus the working capital to fund rapidly growing inventory. This would be typical for all rapidly growing manufacturing companies and does not by itself indicate a problem.
These companies only get into a problem if demand for solar modules diminishes. I posted an article on my website: examiner.com/x-325-Glo...~y2008m5d20-Solar-Cell... where I explain why I think there will be no shortage in demand for solar cells.

[ccerenz2]

Envoy,
This piece is an excellent example why bean counters don't run the world! (Of which I am one) It appears you avoid or miss the most critical point. Why are they cash flow negative? Because they have so much demand for their product that they are racing to build new capacity as quickly as possible. It's not because they are shipping dollars with each panel--it's because they are investing in themselves so they can make even more money tomorrow!
If they run out of financing sources, they will slow down their expansion plans. The only way this story ends badly is if someone builds a better product and renders them obsolete. Of course, this is a risk for every business in the world. Sorry Envoy, the world understands the solar story and it will be a long time before maturity is reached.
But please, continue writing these pieces so I can buy at even cheaper levels.

[oatleaksbeans]

The Chinese solar firms are growing 300% a year! That is an amazing growth rate. So of course they are using lots of cash. They realize that if the grow slowly they will not survive as firms. It is a race for market share and toward efficiencies of scale and cost reductions. If they don't find their price reductions they will also need to worry more about competing solar electric technologies.

So as investors we want them to grow as quickly as possible. But of course it is a tightrope.

My sense is that the Chinese government is very supportive of growth and gaining scale needed to dominate the world market.

Am I wrong in saying that the Chinese government will provide resources to companies that start falling off the tightrope?

Relax... seems like this may be a good period to buy solar stocks.

[akapital9]

Yup, much of this analysis applies to cash/credit/inventory issues inherent in any business and is not inherent or specific to solar.

Thus, one must question the motive of the author...shorting the sector I assume?

[Dan Brooks]

I particularly want to ask about this paragraph:

"Moreover, considering the tremendous amount of capital expenditures still needed by these companies to ramp up production to meet demand, it should be obvious that polysilicon-based suppliers are starving for cash. However, since the industry is currently oversupplied and suppliers have little differentiation, it seems clear that there is a significant risk that these companies could face a cash crunch should investors grow tired of financing these companies."

In one sentence you talk about needing to ramp up to meet demand, in the next you talk about oversupply. You cannot talk out of both sides of your mouths and be taken seriously.

Lets look at Yingling. At 2006 year end YGE had shareholder equity of 68.5 million RMB. At the end of 2007 YGE had shareholder equity of 4 billion RMB. This is an increase of 3.3 billion RMB. Given the current exchange rate of about 7. this equates to an increase in shareholder equity to the tune of about $470 million USD. And you complain it was a poor use of cash? $300 million to create $470 million in value?

Yingling also increased their cash position from under $10 million USD to $132 million USD at the end of 2007.

Given these metrics I think it is very unlikely YGE will struggle to find additional financing to complete the last third of their expansion plans to 600 MW, if in fact they have the need to raise additional financing.

Coincidently YGE announced today that they have completed their second phase of expansion increasing their manufacturing capability to 400 KW from 200 KW.

Disclosure: Brooks Finnacial currently holds an extremely small position in YGE. We prefer a more diversified approach which can be found in select clean energy ETF's such as PBW and PBD.

[Dan Brooks]

I particularly want to ask about this paragraph:

"Moreover, considering the tremendous amount of capital expenditures still needed by these companies to ramp up production to meet demand, it should be obvious that polysilicon-based suppliers are starving for cash. However, since the industry is currently oversupplied and suppliers have little differentiation, it seems clear that there is a significant risk that these companies could face a cash crunch should investors grow tired of financing these companies."

In one sentence you talk about needing to ramp up to meet demand, in the next you talk about oversupply. You cannot talk out of both sides of your mouths and be taken seriously.

Lets look at Yingling. At 2006 year end YGE had shareholder equity of 68.5 million RMB. At the end of 2007 YGE had shareholder equity of 4 billion RMB. This is an increase of 3.3 billion RMB. Given the current exchange rate of about 7. this equates to an increase in shareholder equity to the tune of about $470 million USD. And you complain it was a poor use of cash? $300 million to create $470 million in value?

Yingling also increased their cash position from under $10 million USD to $132 million USD at the end of 2007.

Given these metrics I think it is very unlikely YGE will struggle to find additional financing to complete the last third of their expansion plans to 600 MW, if in fact they have the need to raise additional financing.

Coincidently YGE announced today that they have completed their second phase of expansion increasing their manufacturing capability to 400 KW from 200 KW.

Disclosure: Brooks Finnacial currently holds an extremely small position in YGE. We prefer a more diversified approach which can be found in select clean energy ETF's such as PBW and PBD.

[Boruma]

Envoy: I disagree with your assessment. (1) This type of negative carry is completely normal in high growth sectors; and (2) Regarding availability of credit, although I agree that the traditional bond market is difficult (currently) I can assure you that the bank market is enthusiastically taking up the slack. The renewable sector (e.g. solar, wind, waste etc.) has become very fashionable for banks and in fact is one of the few areas of banking that is expanding since the credit crunch began a year ago - a quick review of the recruitment pages will verify this.

Disclosure: Although I work in project and energy (bank) financing however I have no dealings with any of the names mentioned in this article.

[aquaculture]

CSIQ generates most of its operational cash-flow from Europe. The $60 mln "huge loss" you are referring to was actually a HUGE CURRENCY GAIN.
Financing cashflow is cash received or expended as a result of financial activities, in this case it included foreign currency management, as practiced by all int'l corporations.
This article deliberately confuses operational, investment and financing cashflows.

[Just a Hick]

Everyone criticizing this author, I recommend you read a book titled Business Fairy Tales by Cecil Jackson.He will point out to you the danger of investing in a company that reports large profits but at the same time reports huge operating cash flow losses.
The author makes a very good point about this industry. I was lucky/prescient that I closed my positions in solar just as we had huge debt and equity financings by this sector a couple of weeks ago.You can usually take it to the bank that after large round of financings are completed in a sector all at once, that sector goes down.I would look for further declines especially in ENER.
Say what you want about me, that's my opinion and I'm sticking to it.

[aquaculture]

This company is the first in the world to produce solar panels from 100 % UMG silicon ($60/kg, 9.5 grams/watt). They also operate one of the worlds largest silicon reclaiming centers. Intangible assets, improved margins: they have just upped guidance for 2008 approaching almost $.9 billion in revenues.

IN Q1 THEY JUST PARKED EUROS IN EUROPE AND MADE $8.2 mln ´OTHER NET INCOME´
THERE WAS A FINANCING CASH FLOW GAIN, NOT AN OPERATING CASH FLOW LOSS.

[azrael]

Please somebody should explain to the author the difference between "earnings" and "cash flow". It is absolutely obvious that a companis that grows the revenues at a pace of 50% or 100% a year cannot have a positive cash flow. It is also true that in the actual enviroment is harder to get a borrowing . But all the other conclusions are wrong and misleading.
Eric.

[gebby]

i could not believe this article. so all of wall street is hood winked. goldman put stp on their conviction list. who is this bozo. buy these solars 4 points down 20-30 up. global warming is real. energy crisis is upon us . the mideast has us over a barrel. yes the charts look scary.

[Daniel S]

Well I'll just chime in to say that they call current assets current because they can be used in the next three months. If accounts receivable is large, its because they are selling product. Some companies always operate with a low cash level. Take CAT for example. One would not consider CAT a high risk proposition, especially in the long run. However, if we use the "Envoy theory of investing" we would never ever consider buying CAT. CAT's receivables stood at $9 billion at the end of last quarter, versus $777 million in cash. With $48 billion in total liabilities, the Envoy theory would say CAT should have went under already. But companies do not need much cash to function, they need current assets higher than current liabilities. What money do we have and is coming in during the next three months, versus what we have going out. Its not about what is in the bank at the moment.

[mwatch]

This analysis has little value in term of valuing a whole company and that is why cash flow analysis is not one of the important metric. Cash flow analysis is only important when cash cow companies are valued as well as companies those are risking of turning down additional fund. These companies are in their expansion stage, they can't not be valued as matured one. Furthur, I don't see any of these companies is in risk of turning down additional fund that is not to say the risk is not increasing.

[widicusf]

It is reasonable to make the case that the homebuilders walked this same path from 2003-2005. Cash poor with massive backlog and record revenues. How does that "backlog" look now???
The weak will fall by the wayside no matter how bright the painted picture may appear.

[aquaculture]

widi:
This blog is about Chinese corporations selling solar products worldwide. The U.S. is only 10% of the solar market. And those people in the U.S. who can afford solar panels are hardly the "subprime-types&q...

[fxtrader07]

the cat is finally out of the bag:
In the latest article 'envoy global' changes tht tone towards an outright negative one on chinese solar companies, finally revealing his true objectives (which was hidden somewhat in the earlier installments though in my perception the language and tone used were already pointing towards it).
Yeah, right. First you raised 'questions', then 'concerns' and now you 'continue to advise to avoid'. Hm. Very telling.

The only thing missing here is that you recommended your darling FSLR outright (you did that in a more subtile manner when bragging about their great cash flow in earlier articles. Never mind that they are the most overpriced solar stock out there - but you sure rather pay up big time for that cash flow and relatively mediocre earnings, right?)
Disclosure none? sure.

[grnacres]

All of American Companies face the same secuation.
30 to 90 Days, When writing article like this you
should compare Chinese Companies to Worlwide companies
Your article has no evidence of Anyone of these companies
will have cash problems. Your problem sounds like
you guys are precidious about Chinese Companies.

[10Q Detective]

Don't leave out the juicy parts, too! To wit:


1. Contrary to statements made by news hounds and industry watchers, the GCL contract will not help will help Solarfun meet expected shipments in the range of 160-180 megawatts for 2008. Look closely, for the contract is just a restatement of an existing — and unfulfilled — contract!

industry.bnet.com/ener.../

2. Founder Yonghua Lu is powering up only his own bank accounts--will all collective monies common from naive ADS shareholders.

industry.bnet.com/ener.../

My Best & Stay in touch!

David J Phillips - Editor, 10qdetective.blogspot....
Contributing Energy Analyst
CNET/BNET