2 Solar Stocks That Look Too Cheap

Includes: GTATQ, PWER
by: MagicDiligence

In perusing over the official Magic Formula Investing (MFI) screens, one sees the common stocks of many currently out-of-favor and possibly declining industries: for-profit education, defense contractors, tobacco firms, hard disk drive makers, solar energy equipment providers...

Wait, solar energy equipment providers? In a value screen? Isn't that a growth industry?

It certainly looks like one to me. This is a market that has increased new installed capacity by a compound 51% annual rate over the past decade, including almost doubling new capacity added in 2010 to over 10 gigawatts. Most analysts and participating firms are predicting 20% growth in global demand for solar in 2011. LDK Solar (NYSE:LDK) earlier this week just upped fourth quarter revenue guidance by 22%, kicking up wafer and module shipment estimates in the process. Does this sound like an industry that should be harboring a number of value stocks?

What about those individual stocks? Perhaps there is some problem with their forward demand trends, or maybe they have poor balance sheets, or the SEC is breathing down their necks, right? There must be some problem for them to show up in a deep value screen.

MFI currently screens 2 stocks that are directly leveraged to the solar industry - GT Solar (SOLR) and Power-One (NASDAQ:PWER). Another, Veeco Instruments (NASDAQ:VECO), has a small thin-film equipment business, but that stock is more closely tied to the LED market, so we'll ignore it for the purpose of this article.

What's wrong with GT Solar? The company makes early-stage solar cell production equipment, and is the #2 provider behind equipment giant Applied Materials (NASDAQ:AMAT).

Is it a poor balance sheet? Nope - the company has $260 million in cash and no debt, as of the last 10-Q filing. A problem with the SEC? No, nothing. Poor forward demand trends? Well, last quarter GT posted a 120% year-over-year increase in revenue, 345% in operating profits. For the fiscal year (ending March), revenue is slated to come in 53% higher than 2010. For 2011, preliminary estimates are for about 12% earnings per share growth, although the company has a history of obliterating analyst targets.

And that's not even considering GT's new sapphire business, which is leveraged to the similarly rapid growth of the LED lighting market and is expected to ramp to nearly $200 million in revenue for fiscal 2012.

For all of this growth, the market is only generous enough to attach a 12 P/E ratio (9.6 forward)? Does that make sense to anyone else? It doesn't to me.

What about Power-One? This company makes the inverters that convert DC current from solar panels into the AC current used for everyday power. Reliability and modularity in product design has allowed the firm to reach #2 market share in solar inverters, up from 9th in 2008.

There must be a poor balance sheet... Nope, $195 million in cash versus just $40 million in debt. No SEC inquiries that we know of. Demand trends look pretty similar to GT Solar - fantastic. In the September quarter, Power-One posted 214% revenue growth and a ridiculous 4-figure percentage gain in operating earnings over 2009. Estimates for fiscal 2011 are similar to GT - about 12% growth over even 2010's blowout levels.

Power-One is a bit pricier than GT, at a P/E ratio of 16 (about 11 against full-year 2010 estimates). But that's like saying Walmart (NYSE:WMT) is a bit pricier than Dollar General (NYSE:DG) - they're both cheap. Investors stand to earn returns on investment through both organic growth and valuation increases. That's how big winners in stock portfolios are made.

I understand the bear case: Germany, the world's largest solar market by far, is accelerating its reduction of feed-in tariffs, causing significant demand pull-forward in 2010. This seems like more of a koala bear argument than a grizzly one. Both China and Italy are expected to provide solar subsidies in 2011, and the U.S. recently extended solar tax credits.

In any case, the day is fast approaching where the solar industry will no longer have to rely on government largesse to grow. In the 1970s, a watt of solar power cost $50. This dropped to $10 in the 1990s, and stands at about $2/watt today. The industry expects this progress to continue, with the cost dropping well below $2 in 2011. Manufacturers are rushing to get solar costs down under $1 per watt, at which price it becomes price competitive with traditional power sources like coal. This cost parity will begin to drive demand in excess of government stimulus, and it is set to happen very soon.

There are fewer things more attractive in stock investing than the combination of value and growth potential. Magic Formula stocks GT Solar and Power-One appear to have both in spades.

Disclosure: Author long SOLR and VECO