China Sunergy's Q1 Earnings and 2011 Expansion Gambit

| About: China Sunergy (CSUN)

China Synergy (NASDAQ:CSUN) recently released its first quarter 2011 earnings which were more or less in line with prior guidance. However, relative to other U.S.-listed Chinese solar companies, CSUN remains an enigma as the industry enters into an era of consolidation. Currently, China Sunergy is positioned somewhere in the middle of what is increasingly becoming a divergent sector. CSUN is generally not viewed as a first tier module manufacturer among Chinese companies such as Suntech Power (NYSE:STP), Trina Solar (NYSE:TSL) and Yingli Green Energy (NYSE:YGE). Yet due to its current scale and potential cost structure, China Sunergy is also much better competitively positioned relative to foreign higher cost producers and/or fragmented single vertical players. Although its recent earnings report does not provide significant near term insight, how the company performs throughout 2011 should clearly differentiate China Sunergy as a winner or loser within the industry.

In the first quarter, CSUN’s revenues declined marginally on a sequential basis from $169.6m to $165.7m due to a 10% decrease in module average selling prices (“ASP”) while shipment volumes remained flat at 98mw. China Sunergy’s main cost component, silicon wafers, did not decline to the same degree and as a result gross margin compressed from 16% in Q4 2010 to 10.7% in Q1 2011. However the company’s shipments and gross margin came within prior forecasts of 98-110mw and 9-10.5% respectively.

As China Sunergy continues in its transition from a middle market solar cell provider to a more integrated branded photovoltaic module supplier, operating expenses should continue to trend higher. Typically branded module manufacturers in CSUN’s peer group spend 3% or higher of revenues on sales and marketing expenses. In the first quarter, China Sunergy’s sales and marketing expenses only totaled 2% of revenues, but this may continue to increase as the company increases its branding efforts in new markets. On a sequential basis, total operating expenses did increase from $8.8m in the fourth quarter of 2010 to $9.8m in the first quarter of 2011.

Consequently, China Sunergy’s net income dropped to $3.5m in the first quarter. On an earnings per share basis, CSUN posted .09 in EPS for Q1 2011. Wall Street consensus was .12 in EPS, but it is unlikely estimates factored in a $1m foreign exchange loss the company recorded. Excluding currency translations, China Sunergy’s adjusted earnings still missed analyst estimates by .01 with an .11 EPS on an operational basis. Based on the company’s currency exposure in the prior quarter, CSUN should have posted a small net foreign exchange gain which was represented by a $1m foreign exchange gain in my estimates. Although on a U.S. GAAP basis CSUN’s .09 Q1 EPS missed my .13 EPS estimate, adjusted earnings excluding all foreign exchange translations came in exactly at my $4.5m operational net income estimate. Unlike operational earnings, net foreign exchange translations are much harder to predict because companies can change either currency or hedging exposure at any time and to any degree without disclosure.

China Sunergy’s first or even second quarter earnings shouldn’t be viewed highly when evaluating the company’s longer term competitiveness. Because CSUN operates at the spot market, recent declines in spot market pricing will likely cause a more significant normalization period for the company compared to many peers. In the past couple of quarters, spot market prices have declined at a very high magnitude as indicated by Digitimes and PVInsights. Module spot market prices have declined from 1.75/watt to below 1.40/watt in the past two quarters. Spot market pricing for solar cells during the same period have also declined from a peak of 1.50/watt to .90/watt as recently quoted. Although price declines for silicon wafers lagged in timing, the magnitude of wafer pricing declines have also been significant from a peak of $4/piece to as low as $2.6/piece.

Since cost components lag by roughly a quarter as newer and lower priced procurement must be blended with higher cost inventory, normalized operational metrics would not be realized until a quarter after spot market declines stabilized. While recent price declines have been extremely severe, pricing at least at the spot market level may be closer to a near term trough. The pricing spread between key verticals suggest many fragmented players are at break even points while less competitive producers may be liquidating inventory at losses. While this environment may last as long as there is inventory to be liquidated at distressed prices, it should not be sustainable if history is a guide.

The fact that U.S. listed Chinese solar companies including China Sunergy have reported Q1 ASPs 6-10% higher than spot market levels during the same period may indicate this divergence between higher and lower tier industry participants. Clearly, the industry is currently oversupplied but demand for low cost bankable brands remain extremely high. STP, TSL and YGE have indicated demand for their panels was double current manufacturing capacity. Even widely perceived second tier suppliers such as Jinko Solar (NYSE:JKS) and Canadian Solar (NASDAQ:CSIQ) not only reported strong Q1 shipments but improving sequential demand into the second quarter. At the same time, a number of industry peers at the less competitive end of the spectrum have recently signaled difficulties as noted in my Trina Solar article which described TSL’s industry consolidation viewpoint.

Consolidation within the industry has created an even greater divide between the winners and the losers. With demand processed through the most bankable brands first, overcapacity has left smaller scale, newer brands, and/or higher cost producers fewer avenues to place their products. Less bankable brands in turn become even less desirable. With only pricing as a weapon, less bankable companies unable to place products have thus resorted to inventory dumping as evident by recent spot market pricing trends. Companies once considered secondary tier brands may have become more bankable as a result of being on the winning side of the dividing line formed by the current supply and demand dynamics.

At face value based on first quarter earnings recently reported, major U.S.-listed Chinese solar companies including China Sunergy appear to be on the winning side of this divide. While CSUN is not the lowest cost producer, its operating structure is still much more competitive than foreign manufacturers or fragmented suppliers that only operate on one vertical. While not as large in scale as many U.S. listed Chinese solar peers, CSUN’s current capacity is still larger and more integrated than smaller scale competition which opportunistically appeared mainly to supply boom periods. While module production is new to China Sunergy, the recently purchased module companies integrated into CSUN’s operations have been in business for several years and thus may have more developed business channels than many brands formed last year to fulfill the large demand gap.

In short, China Sunergy is still well behind industry leading peers such as STP, TSL and YGE on many metrics, but the company is probably still better positioned than many even less bankable peers. After all, most industry observers still expect the overall solar industry to remain flat or grow as much as 30% in 2011. As a result, while overcapacity exists, overall global demand may still be strong enough to encompass the capacity of select lower tier suppliers such as CSUN. Like other direct peers, China Sunergy reiterated 2011 shipment targets of 670-690mw which would represent annual shipment growth of almost 100%.

This however is the bullish case for China Sunergy and the company is not without risks moving through 2011. There are still a number of issues investors need to recognize which could dramatically impact CSUN’s corporate profitability and even future survivability. Even despite a much lower reported net income in Q1 and presumably even less profitability in Q2, the company’s shipments have remained relatively strong. The company’s strength in shipments have come at a cost, however, as accounts receivables rose significantly in Q1 2011 from Q4 2010 levels.

On a sequential basis, receivables rose from $65.6m to $156.3m in the first quarter. While this trend was also evident among peers, it is more significant for lower tier companies. High tier companies such as TSL can be selective in choosing its customers, and the company has chosen to do business more at the systems development level rather than the distribution level. Modules sold to systems developers for solar projects already have volumes allocated and thus the risk module shipments wouldn’t be consumed is low. On the other hand, modules shipped to distributors have greater uncertainty on its rate of consumption.

In the past, companies have had to take charges due to the inability of distributors, especially smaller local ones, to pay receivables as demand undesirably changed. In essence, large increases in accounts receivables might be viewed as “stuffing the channel” especially if made to a lower tier customer base. For China Sunergy, this remains to be seen. It in no way suggests CSUN is stuffing the channel to questionable clients, but its accounts receivable risk is greater than tier one peers. The company did note that the vast majority of its receivables are insured so the ultimate risk may be limited.

In addition, China Sunergy’s balance sheet continued to erode in the first quarter. On a sequential basis, total cash declined to $162m from $191.5m while short term debt increased to $209.2m from $139.5m. As described in my prior CSUN article, the company’s net cash balance (total cash minus total debt) went from a positive $33m in Q3 to a negative $22m in Q4 2010 to an even greater negative $122m in Q1 2011. The shift in the company’s debt ratios is the result of its two module manufacturing units purchased late last year as well as a large expansion slated for this year which involves $138m of capital expansion costs. If China Sunergy loses its $50m arbitration with REC, the company’s debt ratio would get even worse.

This is why China Sunergy is somewhat of an enigma compared to larger U.S.-listed Chinese solar peers. For the two years in 2009 and 2010 during a generally under-supplied demand boom for the industry, CSUN did not expand capacity. However now as overcapacity is evident, China Sunergy is embarking on its most aggressive expansion phase in the company’s history. In short the company is making a large bet the divergence between winners and losers caused in an industry consolidation period started this year that would leave China Sunergy on the winning side.

As detailed above, if global demand is strong enough to encompass CSUN’s capacity as weighted on a relative bankability basis, the company should meet its aggressive shipment target for 2011. As operating metrics start to normalize after cost components blend lower to fully reflect current market pricing, gross margin should improve for China Sunergy. Combined with implied second half volumes almost 50% higher than first half shipments, CSUN’s second half 2011 profitability could return to levels seen a year ago. At the very least, it should be apparent that the risk uncertainties for China Sunergy’s optimistic scenario is much higher than larger tier one counterparts. The current industry dynamics don’t rule out CSUN’s success on current guidance, but it should be noted failure could also lead to steep consequences for the company given its weaker balance sheet.

Regardless on what may ultimately happen in the second half, there isn’t too much to look forward to regarding China Sunergy’s current second quarter. Real time module ASP declines coupled with delays in inventory cost blending should cause margin pressure for the company. CSUN officially guided second quarter shipments to range between 120-130mw with gross margin between 7.5-8.5% on a consolidated basis. Also noted in the company's conference call, average selling prices for modules is also expected to range between 1.55-1.65/watt. However, given CSUN’s recent execution record relative to guidance, realistic estimates should be made at the lower end of the company’s guidance range. If Q2 metrics are within guidance parameters, then further upside would be possible.

China Sunergy Q2 2011 Earnings Estimate:

Revenues: $185.5m
Shipments: 115mw module @ 1.57/watt, 6mw cell @ .84/watt
Inventory Costs: 59 x 1.55 = $91.5m
Production Costs: 30 x 1.51 = $45.3m, 70 x 1.37 = $95.9m, 80 x 1.40 = $112m
Blended Unit Cost: $91.5m + $45.3m + $95.9m + $112m = $344.7m / 239 = 1.44/watt
Gross Profit: 115 x .13 = $15m - $1m off-spec cell dilution = $14m
Gross Margin: $14m / $185.5m = 7.6%
Operating Costs: $9.5m
Net Interest Expense: $2.5m
Tax: $.3m
Net Income: $1.7m
Diluted Share Count: 40.1m
EPS: 0.04

The estimates above only reflect the company’s operational earnings power and exclude non-operational items such as foreign exchange translations as well as other unannounced gains or losses. Assuming currency and hedging exposure did not materially change from the prior quarter, a slight gain in the euro vs. the U.S. dollar since the start of Q2 should result in a small net foreign exchange loss. However with almost five weeks of currency trading left in the quarter, it would be impossible to estimate China Sunergy’s net foreign exchange translations as of today’s date.

Disclosure: I am long TSL, YGE, JKS. No Position in CSUN, CSIQ, STP.

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