The Trouble with Chinese Solar Companies

by: John Cordes

Chinese solar companies are beset with undervaluation and undecipherable volatility in spite of amazing growth in sales, net income and future contract commitments. It even seems irrational to many amateur investors, who can't determine the logic for comparative valuation to stocks like First Solar (NASDAQ:FSLR) and SunPower (NASDAQ:SPWR). The overwhelming theme of most submissions to Seeking Alpha is, "what's up - why the movement?" Even professional analysts appear confused with conflicting assessments and frequent reversals.

The obvious answer is: It is irrational. But it's also predictably irrational. Much like oil futures. Demand decreases, production increases, yet prices increase on rumor, while the same rumor one week later produces no effect. For example, both are cited as being driven by value of the dollar. Did the dollar go up 6% yesterday? That doesn't account for the sell off levels.

Are European solar subsidies teetering on collapse? Not likely. Will the trend toward solar subsidies increase world wide in spite of a given country's rumored pull back from subsidy levels? Of course, it's a macro-trend. More solar support is inevitable, especially by 2010. Perhaps even the US Congress will finally pass a bill by then.

So why are the Chinese solar companies undervalued compared to American companies like FSLR? Why are they so volatile in spite of consistent earning and sales improvement? Again, it's similar to oil, in my opinion. Many investors do not quite understand the near term dynamics of the situation, so they trade on rumor and momentum, even though the long term has a seeming inevitable outcome. Is China a reliable economic and political environment for business? Or will they somehow nationalize or confiscate the ownership of these businesses? (Answer; No, China's never looking back again from this economic success. They have taken the lesson of the Shanghai experiment and the absorption of Hong Kong to heart and it has shown the path. China will broaden theses effects throughout the country.) Even Cramer has irrational bias against China for this fear and lack of understanding of this historical trend.

Admittedly, financial disclosure in reading Chinese ADRs is more opaque by American standards, without GAAP reporting and SEC filings. Any China investor has to take a little bit of a leap of faith that the numbers are real. (I recently explained to a friend that I don't consider this as big a problem as he does because the penalty hanging over the head of a publicly held Chinese company CEO or Board of Directors is most likely more onerous than anything the SEC is likely to do to malfeasant American CEOs and Boards of Directors. It's unlikely  that you'll see any ENRONs in China. In the United States, a CEO is more likely to get a "golden parachute" than go to jail for gross negligence or fraudulent insider activity. The penalty in China is likely a bit more draconian, after all.)

Will inflation kill the golden goose in China? Possibly, but how can analysts constantly predict the China slow down and simultaneously tout inflation as the biggest threat? China's problem is similar to ours; as oil explodes up, so does inflation; if it's pulling back, at least for awhile, then we and China will also feel relief on most of the COLI indices, along with the rest of the world. In the United States, we don't quite believe the solar revolution is going to happen, even though Europe is already in the throws of it. After all, Congress has had the renewables bill blocked or defeated 8 times this year; one candidate keeps talking about a nuclear reactor in every back yard, and our current energy policy is the product of an oil company's CEO's meeting in the back room.

Therefore, there is yet an element of unreality to solar in this country. (Incidentally, because of this, I consider the best current play to be Evergreen Solar (ESLR), constantly beat down for lack of net earnings, yet increasing 2008 sales by a factor of ten and manufacturing infrastructure to go with it. ESLR has the one advantage that no Chinese solar company has - it's American, and any likely renewables bill will undoubtedly favor American companies over Chinese. Ergo, the value play and the future momentum play is in this stock.)

Finally, volatility begets volatility. Burned once, you'll be very careful in the future, prepared to pull the trigger on any hint of implosion. When the stock seems to be moving in either direction, you don't want to be left behind. It may be trading for undecipherable reasons, but the direction is clear. All this means is, trust the fundamentals and your own analysis. If LDK Solar (NYSE:LDK) has beat estimates by 200%, increased earnings outlook, never failed to surprise upside, has planned and completed vertical integration, manufacturing capacity and secured raw material, then it will be a winner in the end. (So trust your own analysis.)

Arguably the smaller companies may dilute holdings to underwrite expansion, but even China Sunergy (NASDAQ:CSUN) and ReneSola (NYSE:SOL) have shown that they can do this without ruining share earnings. Some might notice that, unlike many small, newly minted public American companies, in the first year mode undergoing extreme growth demands and vast new financial wealth after an IPO offering, the Chinese companies will quickly show positive earnings, and reasonable M & A components, and option gifts and insider trading is not a significant line item expense at the end of the year. (Compare that concern with virtually any new American pharmaceutical or hot sector IPO on the OTCBB. Such greedy behavior/malfeasance is not likely to be tolerated in China, and the CEO and CFO are not likely to be building an offshore bank account, unless their family lives in another country and their tolerance for a labor camp is very high.)

Chinese capitalism seems to be an oxymoron, and solar hasn't yet been bought into by many investors. Chinese inflation is a subject of constant speculation and the European market for Chinese wafers is the only tangible measure many analysts can identify. What's left to trade on? Momentum, that's what. I say trust your own analysis, trust the reported numbers, trust in the macro-trend, and (this may be a bit harder to do) trust in the fact that the new China miracle is not going to go retro because of some resurrection of Communist ideology intent on self-emulation. How do I know? How about the biggest two week display of newfound pride and affluence paraded before the world in what was supposed to be the Olympics, but actually turned out to be a Chinese coming-out party. Or did anyone fail to notice that?

Disclosure: Currently long in LDK, CSUN, and ESLR