Yingli Green Energy-Dupont Deal: A Sign Of Things To Come?

| About: Yingli Green (YGE)

Earlier this week, DuPont (NYSE:DD) announced a $100m strategic agreement with Yingli Green Energy (NYSE:YGE). Under the terms of the deal, Yingli would purchase consumables used in the manufacturing of solar modules such as metallization pastes and protective backsheets. This bit of news by itself is not very significant, but may be more noteworthy ahead of a U.S. Dept. of Commerce preliminary hearing regarding potential tariffs on Chinese solar imports currently scheduled for March 2, 2012. In fact, this deal was organized by the U.S. Dept. of Commerce as well as the Ministry of Commerce People's Republic of China and hosted by the U.S. Chamber of Commerce.

Whether it is a prelude to an important decision approximately two weeks from now, or simply a peace offering by China, only time will tell. Trade friction with China is nothing new and similar periods of saber rattling followed by symbolic agreements may be the new norm. As the photovoltaic solar industry expands globally, trade relations and its impact between the U.S. and China will become much more significant.

Recent tension began when a coalition led by Solarworld accused Chinese module manufacturers of dumping products which led to a collapse in pricing. As with most arguments, there may be some validity to this claim. A general oversupply in the industry triggered a cascading collapse in pricing which started earlier last year. As pricing dropped below the cost structure of less competitive peers, production halts, inventory liquidations, and bankruptcies followed.

By definition, a lot of companies in the photovoltaic solar industry were "dumping" in recent months as inventory was sold below cost in order to free capital. While collapses by larger western solar companies were more publicized, undoubtedly a large number of smaller scale manufacturers have been hit equally hard.

Research reports by Digitimes estimated up to two thirds of China's capacity had been shut down. Consequently, modules sold at below the cost structure of China's most efficient producers such as Trina Solar (NYSE:TSL) and Yingli may have ended up in the U.S.

However, this claim has not been true regarding larger Chinese solar companies, namely those listed in the U.S. markets. As noted in my recent TSL review, Trina Solar's gross margin for its latest reported quarter was positive. Excluding a time inventory provision, Yingli's third quarter gross margin was a high 19%. Suntech Power (NYSE:STP), the largest crystalline module supplier in the world, also reported positive gross margin for its latest reported quarter.

During a quarter where average module pricing fell below 1.00/watt, China's three largest suppliers reported module average selling prices ("asp") at 25-30% above spot market levels. By selling at market premiums and above production costs, Trina Solar, Yingli, and Suntech Power- in this example- have not "dumped" but rather have been victims themselves of the recent industry wide consolidation cycle.

Below cost dumping was only part of the argument. Although not new, other claims of illegal subsidies by the Chinese government in supporting its native solar industry have been also made. I had already written over a year ago when similar claims were made by the U.S. steel industry against Chinese solar imports. As U.S.-listed public companies, China's largest module manufacturers, such as Trina Solar, must abide by U.S. GAAP accounting which are audited by reputable global auditors, typically the same firms auditing U.S. solar companies.

Typical claims of unfair tax breaks to free capital as I detailed have not been true. Recent claims have also been made regarding billions of dollars in loans were equally misplaced. In fact, using Trina Solar as an example, peers (including large U.S. solar companies) have had more local government support in the form of larger lower cost loans as well as higher degrees of tax benefits and subsidized utility costs.

Ironically, even as various interest groups in the U.S. triggered tensions with China's solar industry, the U.S. has been a net beneficiary in trade with China. As I detailed in a prior article, up until 2010, the U.S. has enjoyed a large trade surplus linked with Trina Solar. As the recent Dupont and Yingli agreement details, trade between the U.S. and China involving solar products has not been a one way affair. Although the final product, the solar module, may be manufactured in China, many components may originate from the U.S.

According to large scale Chinese manufacturers such as Trina Solar, Yingli, Suntech, and LDK Solar (NYSE:LDK), approximately two thirds of the processing costs for a solar module are comprised of materials such as consumables. Less than 10% is labor, while the remaining portions of the processing costs are split between utilities, depreciation, and misc. costs. In addition, polysilicon has ranged from 40-80% of a crystalline solar module's unit cost. In other words, 80% or more of a module's unit cost is comprised of raw materials and generally less than 10% is labor.

Material procurement has come from a variety of sources, including many U.S. companies. Dupont has just identified Yingli as a purchaser of metallic paste and backsheet. STR Holdings (NYSE:STRI) noted Suntech was one of its two largest customers in its 2010 annual report. LDK Solar has procured crucibles used in silicon ingot production from a Californian company. GT Advanced Technologies (GTAT) has sold multicrystalline casting furnaces as well as polysilicon reactors to at least Trina Solar, Yingli, and LDK. Hemlock and MEMC Electronic Materials (WFR) has sold or has agreements to sell polysilicon to Trina Solar, Yingli, and Suntech. Although Applied Materials (NASDAQ:AMAT) did not break down details, 24% of its fiscal 2011 consolidated revenues were to China and almost $2 billion of its sales were solar products such as equipment for wafer and cell manufacturing.

In Yingli Green Energy's situation and much like Trina Solar in the past, very little revenue was derived from U.S. sales. According to its 2010 annual report, less than 10% of its 2010 revenues were from the U.S. For 2011, Yingli expects 14% of total shipments, or roughly $310m, to go to the U.S. In addition to the recent $100 million Dupont deal, Yingli has a 7 year polysilicon deal with U.S.-based Hemlock, one of the largest polysilicon producers in the world. As with Trina Solar, after all considerations, the U.S. may have enjoyed a cumulative trade surplus with Yingli.

In fact, a GTM Research and SEIA report estimated the U.S. enjoyed a $1.9 billion solar trade surplus with the rest of the world in 2010, with as much as $540 million surplus with China. With Chinese penetration into the U.S. markets even smaller in prior years, past solar industry trade surpluses with China were undoubtedly higher in proportion. Of course, as the solar market in the U.S. continues to expand and as large scale Chinese module manufacturers capture higher global market share, past surpluses may inevitably turn into deficits.

Photovoltaic modules are only part of the value chain for solar projects. System costs, such as EPC ("engineering, procurement, construction") for solar projects, have ranged from $2.00-$4.00/watt, depending on the scale. Trina Solar announced it sold a project approximately 4MW in size for $22.4m in the third quarter, or slightly over 5.00/watt total costs which included financing. A larger 550MW First Solar (NASDAQ:FSLR) project implied total costs around 2.90/watt. With module costs hovering around 1.00/watt currently, systems related costs including financing could comprise 65-80% of a solar project's total costs.

Unlike a solar module which may be imported, systems related costs could be entirely domestic and local. Thus excluding whatever portion of a 1.00/watt Chinese imported solar module could be traced back to the U.S., every dollar spent on an imported Chinese module could generate two to four dollars in domestic revenue required to build the solar project. As such, it is not hard to rationalize how tariffs, which would raise the cost of solar projects potentially to the point of unfeasibility, could damage more than benefit the U.S. solar industry. A recent CASE report estimated solar tariffs could cost the U.S. up to $2.6 billion and nearly 50,000 American jobs over three years.

In the past several years, the solar industry has been on a clear path of reducing costs to electrical grid parity without the need for any subsidies. Although subsidies were required in the past, prices have dropped to levels where grid parity has already been achieved in certain solar-friendly regions. Even in Germany, feed-in-tariff rates for ground projects have already dropped below the residential grid of approximately 0.23euro/watt. Price elasticity resulting from lower costs have generated a surge in global demand to as high as an estimated 25-28GW in 2011, up from 16-17GW in 2010. Conversely, higher costs resulting from potential tariffs could dampen demand in the U.S., which could potentially be an overall economic negative.

Saber rattling and trade disputes may always exist. However, with not just two companies forming a strategic agreement, but two nations also participating in the event, perhaps this foreshadows more constructive relations moving forward, from which both countries could benefit.

Disclosure: I am long YGE, TSL, LDK.

Additional disclosure: No position in DD, STP, FSLR, WFR, STRI, GTAT, AMAT, and Solarworld.

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