First Solar (FSLR) released its Q3 results after the market closed on November 2nd to what appeared to be a resounding thud. While First Solar continues to try to prove it can remain a viable and profitable organization, the industry in which it operates is challenged, and that's putting it mildly. Over supply has caused fierce price competition, putting severe pressure on profit margins, while government subsidies, which have promoted strong growth in solar power in recent years, have been cut in many countries while being at risk of being cut in many others.
First Solar, in recognition of these growing challenges, developed and communicated a comprehensive change in strategic direction, which can be found on the company's website and is further detailed within its 2011 Annual Report. The three basic components of the strategy can be summarized as follows:
- Sales Focus - Greatly reduce the company's historical focus on component sales, which involves design, manufacture, and sale of solar modules to third-parties and instead focus on its fully integrated systems business. Doing so means providing complete PV solar power systems, comprised of its own solar modules, including project development, engineering, procurement and construction, as well as operating and maintenance services. The projects are sold directly to investor owned utilities, independent power developers and producers, commercial and industrial companies, and other system owners. This change in focus was meant to help grow its sales while protecting margins, albeit, lower margins than the company had historically achieved before the over-supply.
- Focus on Sustainable and Growing Markets - Most of the company's historical sales have come from markets where government support through subsidy funding was strong, (i.e. - Germany and the US). Unfortunately, many of these countries have cut such funding or are at risk of cutting it. In order to mitigate this risk, First Solar has chosen to diversify its geographic sales focus which has led to newly announced contracts in developing markets such as India, Australia and Dubai.
- Cut costs - There were three primary areas on which the company chose to focus; R&D, Manufacturing and its European operations. Amongst other things, this led to the elimination of 100 R&D type positions, the cancellation of multiple manufacturing expansion projects, including its previously announced 4-line plant in Vietnam, and the extensive reduction of its European operations, including the forthcoming closure of its Frankfurt plant in Germany.
Three quarters have now been reported since First Solar announced its strategic change in direction. Given investor reaction to Q3 results, perhaps it's time for us to examine how it has fared so far.
Sales - YTD sales now sit at $2.29B versus $2.10B last year, representing a 9.05% increase year over year. More importantly, updated guidance from its Q3 report is to achieve $3.5B to $3.8B for the full year, which, compared to last year's $2.77B, would represent between a 26.35% to 37.18% increase in sales year over year. To put this growth in perspective, 2011 growth year over year was only 7.92% while 2010 year over year growth was 24.06%. Of note, the updated guidance would suggest Q4 sales to be between $1.21B and $1.51B, representing a huge increase from Q4 last year of $660M. Is this sales level sustainable? Well, according to the financial presentation and conference call for Q3, there is $8.9B in current projects in its pipeline, a large portion of which relates to projects with scheduled completions before the end of 2014. As such, it would appear these sales levels will continue to grow for least the next several years.
Operating Margins - Much has been made of the tightening margins, with many analysts and investors focusing on year over year gross profit margin comparisons. Given the margin squeeze was anticipated versus prior years, I believe the more pertinent information, in relation to sustainability and future value, is found by focusing on sequential quarters since the change in strategic direction. If we look at the final quarter of 2011, gross profit margin had already dropped all the way to 20.92%. Unfortunately, it did not stop decreasing as First Solar reported an even lower 15.44% gross profit margin in Q1 of 2012. Since then, however, there have been promising signs of stability. In Q2, the company reported 25.46% followed by Q3's reported gross profit margin of 28.45%. While not at historical levels, gross profit margins have been stabilizing. It is unlikely that we'll again see profit margins in excess of 40%, however, as was seen in the past two quarters, the company can be very profitable on the bottom line while running with gross profit margins between 25% and 30%, especially when sales volumes have increased so dramatically. While there are many reasons for the increase and stabilization of profit margins, the largest impact has come from First Solar's manufacturing and utilization efficiency improvements that have led to a 6.9% decrease in the cost per watt year over year, which now sits at $0.67 as of Q3.
Earnings - As with operating margins, I feel the most pertinent analysis is to focus on sequential quarters as it relates to future sustainability and effectiveness of the change in strategic direction. In Q4 of 2011, First Solar reported $1.26 per share in adjusted earnings, which exclude the impact of restructuring, goodwill impairment or certain costs in excess of normal warranty expenses. Given the low gross profit margins experienced in Q1 of 2012, it is not surprising that the company then reported an adjusted loss of $0.08 per share. However, since that time the company has returned to profitability, reporting adjusted EPS of $1.66 in Q2, then $1.27 adjusted EPS in its most recent Q3 results. Given these results, and as I eluded to above, First Solar's new model of operating with 25% to 30% profit margins, on what has thus far been average quarterly sales of $900M, results in a very profitable company. Additional evidence in support of this statement comes from the company's updated guidance given at Q3. First Solar has said it will deliver between $4.40 to $4.70 in adjusted EPS for fiscal 2012, which calculates to between $1.55 and $1.85 adjusted EPS for Q4, dramatically higher than the $1.26 per share reported in Q4 of last year. Based on anticipated Q4 adjusted EPS, the final three quarters of 2012 will have resulted in at least $4.48 adjusted EPS. Assuming Q1 of 2012 will not likely repeat itself, we can annualize adjusted earnings to at least $6.00 per share.
Balance Sheet and Cash Flow - While we continue to discuss adjusted earnings per share, I should point out that I am not a huge fan of anything that is non-GAAP. In the end, one-time expenses and write-offs have an impact on the book value of a company which can sometimes be significant enough to put a company offside on certain loan covenants. As such, I tend to analyze what type of write-offs are being made, the dollar value of these expenses and their overall impact on the balance sheet, not to mention the impact on book value versus market capitalization. In the case of First Solar, over the past four reported quarters, it has taken a goodwill impairment charge of $393M and restructuring charges of $505M. Even after these one-time charges, First Solar's reported shareholders' equity at Q3 was $3.46B, versus the $1.96B in market cap as of the end of trading day on November 2nd. Equally strong is the company's current ratio of 2.37:1, which is a great measure of short-term liquidity. First Solar's current ratio is basically saying it can cover all of its current liabilities 2.37 times based on the value of its current assets. I also like to look at total debt as a percentage of current assets, which is to say, if First Solar had to pay all of its liabilities under the assumption that long-lived assets would be difficult to liquidate or bring little value, what would it look like. In this case, First Solar has 107% of all its liabilities covered by its current assets, which is extremely strong. As one more check on liquidity and financial strength, I like to examine the statement of cash flows to determine the sources and uses of cash. In the case of First Solar, for the nine months ended on September 30, the company generated $434M in operational cash-flow, using $344M to support its capital program and investing activities, while financing activities netted to an overall re-payment of debt in the amount $84M. The result of these activities was to leave an ending cash balance of $615M. In essence, First Solar generates enough operational cash flow to fund its capital program while also allowing it to pay down debt, versus having to raise further capital or take on new debt to fund operations. Based on my analysis, there is nothing about the cash flow or overall liquidity of First Solar that would raise any red flags. In fact, it would appear the company has a very healthy balance sheet and is in a very strong financial position.
So, how does all of this translate into the future valuation of First Solar? Well, let's go with what we know. Based on the communicated project pipeline, it is expected sales will continue to grow over at least the next three years while gross profit margins seem to be stabilizing and could easily remain over 25% on an annualized basis. With restructuring expected to wind down by the end of this current year, it is not unlikely that adjusted EPS experienced in the final three quarters of 2012 should replicate themselves over the next three years as well, meaning at least $5.50-$6.00 adjusted EPS per year over that time frame, (and I see this as conservative). As such, it is not unreasonable to use an estimate of $5.50 EPS as a basis on which to value the company. While multiples vary, the current trading value of approximately $22.54 (closing price on November 2), assumes a multiple of 4.10 on forward EPS. Given the apparent stability for the coming 36 months, one could argue this multiple results in a dramatic undervaluation. In the event the next several quarters' results play out as expected, using what we know, more reasonable multiples of 8 to 12 times EPS could be approached. If this happens, we could see the share price easily double before the middle of 2013. While I see First Solar in terms of a long-term opportunity, it should be noted once again that 4th quarter sales guidance is to more than double last year's Q4 sales of $660M. It would also be expected that Q4 gross profit margins will be greater than 25% versus last year's 20.92%, while guidance suggests growing adjusted EPS to between $1.55 and $1.85 versus last year's $1.26 EPS. If the company is able to deliver on this, which it would at least appear the company can, one would have to at least consider the positive impact on the share price versus current levels.
Are there continued risks for First Solar? Absolutely. That said, over the next two years, First Solar has communicated that it will be working hard to fill its pipeline with new projects in developing markets, while continuing to develop projects in the US. Given the strength of its balance sheet and sales pipeline, it has bought itself plenty of time to do just that. While the solar industry has fallen out of favor over the past year from an investment perspective (understandably), over the longer term, governments will have no choice but to continue to invest in alternative energy sources. As the cost of power generation increases, (as it has over the past decade), and the price of power escalates to the end consumer, the economics of solar projects like those developed by First Solar become more and more attractive to potential buyers and partners, as we have already witnessed with names like GE (GE) and Berkshire Hathaway (BRK.A) investing in First Solar developed projects.