JA Solar: Undervalued, Despite Cyclical Weakness

| About: JA Solar (JASO)
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There have been pronounced changes to the landscape of the crystalline photovoltaic industry in the past two months. Most notably, average selling prices (“ASP”) across all four major crystalline verticals have declined significantly since the beginning of May. Many companies unable to operate in a lower pricing environment have curtailed or shut down operations. In other cases, margins have contracted for companies still competitively positioned enough to generate profits. However, even some well-positioned solar companies have had to alter strategic business models in order to maintain longer-term profitability.

JA Solar (NASDAQ:JASO) reported its Q1 2011 earnings early in May, which came well ahead of the majority of ASP declines witnessed throughout the month. Although the obvious impact from ASP declines would likely cause its Q2 earnings to deviate negatively from guidance given at the time, JASO also announced a number of additional events which appear connected to recent pricing activity in the solar industry.

Last week, JA Solar announced the purchase of Solar Silicon Valley, a silicon wafer producer in China. Although augmenting vertical integration is an obvious strategic move to reduce manufacturing costs, this transaction also highlights several other interesting details.

The first question many analysts asked during JASO’s conference call regarding this acquisition was why now? Silicon wafer pricing had dropped significantly in the past two months to levels where only a handful of very large scale or very efficient producers could actually generate gross profits. While JA Solar noted the transaction was valued at 0.38/watt per capacity installed (half the capacity price Suntech Power (NYSE:STP) paid last year with its Rietech purchase) and only 2.6 times 2010 net income, trailing valuations offer little insight, especially when current margins could be dramatically lower in today’s pricing environment.

Other questions arose given Solar Silicon Valley’s purchase is a related party transaction. In essence, 70% of the acquired company is owned by Jinglong Group, a company controlled by JASO’s chairman, Mr. Baofang Jin. Although JASO stated the transaction was done at an arm's length with an independent committee and Goldman Sachs as an advisor, the timing as well as related party connection may cause some to believe it was a bailout of the same chairman’s holding. JA Solar did imply Solar Silicon Valley’s gross margin was positive and that the deal would be accretive to JASO’s own gross margin. Thus, while the acquisition may raise a lot of questions, it does seem financially justifiable ... especially if other intangible technical synergies the company emphasized become realized.

An amendment filed today to JA Solar’s 2010 annual report also offers insight on its recent acquisition. While the amended text of risks and uncertainties is nearly identical to the original annual report, three notable additions were made:

  • OCI Company Ltd. was added as a polysilicon/silicon wafer supplier.
  • Mechanisms for pricing adjustments on contracted volumes range from 5-10%.
  • Supply contract breaches may result not only in prepayment forfeits but also litigation.

In other words, recent ASP declines in polysilicon and/or silicon wafers may cause JA Solar to default on legacy supply agreements if the company determines by doing so is in its best financial interest. Since JASO has made substantial prepayments, directly or indirectly, to Solar Silicon Valley, fully acquiring the company would be the easiest fix to legacy supply agreements based on less flexible pricing terms. STP essentially did the same last year with its purchase of Rietech by salvaging a minority stake gone bad with an outright purchase.

While some media reports indicate GCL-Poly (Hong Kong) as the supplier risk in today’s annual report amendment, it is highly unlikely that this is the case. GCL has already proven its commitment with strategic partners by being extremely flexible on pricing. JA Solar was one of the first and the largest GCL customer in terms of contract size when the first deals were made in mid-2008 at much higher pricing levels. Despite dramatic ASP declines that ensued after the financial crisis in late 2008, GCL customers were able to renegotiate terms even when many other companies wrote off higher-priced supply agreements. Additionally, despite tightness in wafer supplies in the past three quarters, GCL’s average silicon wafer selling price remained approximately 20% below spot market levels.

Since GCL also is a low-cost polysilicon producer, it is one of the few silicon wafer suppliers in the world that can remain profitable even at recent spot market ASPs. As a result, GCL is more likely to be flexible with strategic partners because it can, while other higher cost providers would lose money. The term strategic partners is used because GCL’s strategy is different than other silicon wafer suppliers. Most of GCL’s wafers are produced co-location with its customers. Being physically connected, it would be in the best interest of both parties to work out acceptable business terms.

With Jinglong’s supply contract neutralized with the purchase of Solar Silicon Valley, and GCL’s contract risk lower due to reasons detailed above, potential outstanding supply contract risks may be with either Wacker Chemie (German), M.Setek (Japan), or OCI (Korea). If polysilicon pricing continues to decline, JA Solar may in the future take a charge against prepayments made for these supply contracts. As amended today, writing off supply contracts may also result in litigation against the company. Most cases have been resolved outside the courts as evident by STP's recent $212m cost to exit a large silicon wafer supply agreement with MEMC (WFR).

Regardless of the financial impact of JA Solar’s Solar Silicon Valley purchase, or potential legal risk for any of its legacy supply contracts, the recent declines in ASPs across all verticals are severe. JASO’s strategy of remaining primarily a solar cell provider with only limited upstream wafer capacity -- and even more importantly lower ratios of downstream branded module capacity -- will be put to the test in today’s solar market. The company has argued that, with strong alignment to high-tier customers, it could remain solar cell-centric and profitable despite lower levels of integration. If JA Solar can maintain shipment volumes at high levels regardless of margins, then its strategy is valid -- at least so far in today’s extremely challenging environment. Many single vertical solar cell peers, even larger-scale low-cost producers in Taiwan, have seen business levels collapse.

JA Solar gave an open-ended Q2 2011 shipment guidance of at least 400MW. Thus far, the company has not altered its limited guidance, unlike US-listed Chinese Solar companies such as China Sunergy (CSUN) and Daqo New Energy (DQ). However profitability levels are almost certain to be lower than expected with the information given at the company’s latest earnings conference call. As a result, I have to lower my prior estimates for JA Solar’s second quarter earnings. While shipment levels are kept constant, I am lowering JASO’s margin profile to reflect the dramatic declines in ASPs in the last seven weeks of the second quarter post its Q1 2011 earnings announcement.

JA Solar Q2 2011 Revised Earnings Estimate:

  • Revenues: $405m
  • Shipments: 260MW cell, 50MW tolling, 105MW module
  • Asps: 0.90/watt cell, 0.27/watt tolling, 1.50/watt module
  • Unit Costs: 0.85/watt cell, 0.22/watt tolling, 1.22/watt module
  • Gross Profit: 310 x 0.05 = $15.5m + 105 x 0.28 = $29.5m, $45m total
  • Incremental Gross Profit: 75 x 0.04 = $3m wafer
  • Gross Margin: $48m / $405m = 11.9%
  • Operating Expenses: $17m
  • Net Interest Expense: $10m
  • Net Foreign Exchange Gain: $1m
  • Derivative Gain: $5m
  • Tax: $3m
  • Net Income: $24m
  • Share Count: 172m
  • EPS: 0.14

Since the quarter has already closed and key currencies rates have been determined at the end of the second quarter, a non-operational net foreign exchange gain of $1m has been included. In addition, JASO should also record a derivative gain linked to its convertible bonds (prior article for clarification). These non-operational items convey higher degrees of error and should only be viewed as directional estimates.

Looking forward, quarterly net income for JA Solar should improve from Q2’s trough levels. While core solar cell ASP has declined for JASO, ASPs for procurement components have also equally declined. As primarily a single vertical solar cell producer, JASO simply makes the pricing spread between the silicon wafer and solar cell vertical. That spread based on recent pricing activity has already bottomed and maintained levels such that JA Solar should maintain or improve its gross margin in the following third quarter. Additional upstream silicon wafer capacity should also add incremental gross profit. Higher levels of even more important downstream solar module shipments would not only help maintain high levels of overall shipments but also improve gross margin under recent pricing trends.

JA Solar’s Q2 shipments and Q3 forecast for shipments will be critical in evaluating the company’s business model. If the company can maintain high levels of shipments, its business model is still valid and profitability should improve from recent severe compressed levels. Any negative adjustments to shipment guidance may force JASO to change its business model and become more of a fully integrated branded module supplier like many of its direct peers.

While cyclical earnings may be weaker than some peers in the near term, the company is still the largest solar cell producer in the world based on 2010 ending capacity. More importantly, JA Solar is still profitable whereas many comparable peers have been experiencing dramatic shortfalls in business levels. Like many US-listed Chinese solar companies, recent market valuations may more than discount uncertainties in the solar industry. Even on annualized and potentially trough Q2 2011 net income, JASO would still trade below 10x earnings.

Disclosure: I am long JASO.