Green Energy, Red Ink: Prospects For Solar In A Recession

Includes: JKS, SOL, STP, TSL, YGE
by: Oscar Sahlberg

It is an undisputed view that green energy and alternative energy will have to be fully integrated in a world that is quickly running out of fossil fuels as its primary source for energy. Yet despite this obvious premise, there is no guarantee about the short-term profitability of the industry. Especially for a nascent industry, growing pains could be quite high. Add to this the fact that the economics of solar still requires subsidies that depend on governments, which are facing big financing woes themselves, the short term is set to be painful for solar stocks.

Before we delve into the analysis, let’s take a 20,000 feet view of the industry. Solar has seen a stupendous growth rate in the past 5 years. This was driven primarily by policy shifts by governments that provided generous subsidies for the industry in light of the upcoming fossil fuel crisis as well as to bulk up their green credentials when public awareness on this issue was developing rapidly. The focus of the growth was the European markets that took an early lead in the installation of solar power as a means to diversify their power generation capacity. With a blip due to the financial crisis, solar company revenues grew at an astonishing rate from nearly $10bn in 2007 to $35bn in 2010. On top of the high subsidies, declining prices increased economic affordability and aggressive capacity increases provided the unit growth that drove the rapid expansion of the market.

Solar has been an industry driven by subsidies. We see that stock performance and the trading multiples have correlated strongly with positive policy developments. Therefore, with the key growth driver being subsidies, the current political environment makes the outlook on the sector weak. With the bulk of the market emanating from European demand, a Euro area crisis is the elephant in the room. The market expects, at varying degrees, that non-European demand (primarily US, China, and India) will pick up the slack. However, this assumes that contagion will not spread and if it does, the periphery will not be affected (Read this for a fantastic read on periphery and the core). With budgets under strain, governments have been/are revisiting their subsidy levels (see Germany, Italy, Spain, France, UK). Furthermore, other countries that are jumping on the bandwagon are doing so at a much lower rate.

Yet the view that the impact of the core will not be as bad, or that the periphery will be able to absorb the supply seems unrealistic. Europe is undergoing a serious crisis, which may either end up in the breakdown of the monetary union, whereby there will be serious repercussions both at the individual country level and general confidence levels, or the stronger partners (Germany) will have to pick the burdens of the fight. Either way, the impact on demand will be negative. Capex decisions will be further delayed, and financial stress will result in an environment where financing will be extremely tough and if it is obtained, the cost will be high. The unravelling of public finances will result in residential consumers slamming the brakes on spending (especially given how conservative the German consumer is). In fact we are already seeing the glimpses of what can happen. There are many large projects that cannot get financing and sentiment of the German consumer is reflected in the German papers, which continue to rip on solar energy.

As a consequence, the market specialists are looking toward an accelerated contraction of the European market. Some even argue that the contraction could simply undo the installation growth seen since the end of 2009! Furthermore, the expectation that the demand will move from large installations to small rooftop systems introduces a further complexity into the business model whereby marketing expenses will increase, working capital volatility will increase and even financing methods will have to be revisited.

The macro backdrop in terms of policy driven demand is further exacerbated by the industry specific developments. The sector continues to see declines in ASPs in every level. However, further price decreases will not have the same magnitude of increase in unit sales. Smoothing out for 2009, my calculations based on an average of industry projections yield that the elasticity levels will nearly halve going forward, which shows that the marginal demand will not be as sensitive to price declines. So growth trajectory for the sector will remain subdued (some analysts do not foresee that we will pass 2010 industry level revenue until 2015.

This reduced sensitivity could result in further margin pressure as the desire to fill oncoming capacity (cell capacity to increase by 45% and wafer capacity to increase by 35%) will have to push prices even lower to fulfil the utilization targets. Some analysts believe that the supply/demand balance will result in surpluses between 1-2GW per quarter until 2013. This is of course a recipe for disaster – an industry with high capex base and low utilization, competing by cutting pricing with decreasing marginal volume increases. This is reflected in manufacturer economics with wafer profits per unit in negative territory and cell profits at 2-year lows, skirting with negative territory.

So while the stocks may look oversold on a technical basis, the view on the sector is that Solar has yet to show solid signs of troughing and that the sentiment stays clearly negative. The fundamentals are not extra bright either. While the US comps – Jinko Solar (NYSE:JKS), Renesola (NYSE:SOL), Suntech Power (NYSE:STP), Trina Solar (NYSE:TSL) and Yingli Green Energy (NYSE:YGE) – look like they trade at reasonable EV/Sales of on average 0.5x, the revenue risk is clearly not baked in. Furthermore, forward estimates do not look good, with only 3 of them expected to turn a profit in 2012 (at an average of over 16x earnings).

While the long-term story stays exciting, investors must be cognizant about not falling into a reversal story until solid evidence can be presented and the current macro uncertainty has passed.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.