Growth With Leverage Or Contract With Collateral - The Case Of Canadian Solar, First Solar, And SolarEdge

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Includes: CSIQ, FSLR, SEDG
by: DTF Capital

Summary

Chinese companies continue to catch up with higher-end solar technologies, meanwhile, flushing the market with cheap solar products.

First Solar, Canadian Solar and SolarEdge are among the most appealing players for the difficult years ahead, but with caveats.

Canadian Solar is well diversified, operationally solid, cheap, but highly leveraged with $1.5bil in short-term debt looming.

First Solar is dubbed as the most technologically advanced player in the industry, spoiled with almost $2bil of cash, but investors are still dumping the stocks.

SolarEdge has a pristine balance sheet, the lowest-cost operator in the inverter market, and the lowest inventory burden coming into 2017, however, priced at a premium.

Difficult Outlook

The year 2017, and 2018, will continue to have an over-supply of solar panels. The main reason is the influx of cheap products coming directly or indirectly from China. The region currently produces 52% of polysilicon manufacturing capacity, 81% of silicon solar wafer manufacturing capacity, 59% of silicon solar cell manufacturing capacity, and 70% of crystalline solar module manufacturing capacity of the world, according to the China PV market trend survey. Moreover, China remains the player with the lowest cost structure for lower range products and is catching up the West in terms of technology. The country is seen as a great threat to many US and EU companies.

China is also widely expected to remain by far the world's largest solar deployment market for many years to come. What it has deployed over the last five years has been nothing short of incredible, overtaking what Germany has deployed in the last 20 years. It is also building production facilities outside of China, partly to counter the import tariffs imposed by the US and EU on Chinese produced solar goods.

The US by contrast accounts for 11% of the world's polysilicon production capacity, and contributes below 1% for wafer, cell, and module manufacturing capacity.

Thesis of Canadian Solar, First Solar, Solar Edge

I believe First Solar (NASDAQ:FSLR), Canadian Solar (NASDAQ:CSIQ) and SolarEdge (NASDAQ:SEDG) are good candidates to weather the bleak outlook of the market. Although these companies are primarily operating in the North American market, their customers in the EU, Africa and Asia are growing steadily. Canadian Solar, in particular, is seeing strong growth in revenue from multiple regions, in particular, 42% of its revenue is currently from Asia. It is also operationally efficient and cheap, but possesses the highest debt burden out of the three.

First Solar, on the other hand, is flushed with cash, has the strongest FCF generation albeit modest and steady top-line historical growth. SolarEdge enjoys the best positives of the two. It has a pristine balance sheet with no debts, high liquidity and exceptional current and quick ratios. It is also the lowest cost manufacturer within the inverter players. It is a newer and smaller company of the three, but it has seen great top-line growth since inception. The low-priced solar module in the short to medium term will also be beneficial for the inverter players. Hence, it also comes with the higher valuation metrics. So, which one suits your palate? Or all three?

The following fundamental analysis will go through areas which I consider important in valuing these three companies.

Historical Revenue and Margins

Canadian Solar was the number 2 solar energy solutions company by revenue in 2015 and has managed to double its revenue between 2013 and 2015, incredible jump whilst First Solar sales stagnated (Investment Conference). Manufacturing costs have shown incredible reduction since 2011, at $1.32/w to $0.33w in Q4 2016 and forecasted to fall further to $0.29w by the end of Q4 2017. However, this jump in sales and reduction in cost did not result in economies of scales. Price reduction meant that gross and operating margins remained at or around 18% and 9% in the last three years, respectively. FCF/sales is a great measure of a company's pricing power or a proxy for competitive advantage. In the last 10 years, Canadian Solar has not possessed any significant competitive advantage. Only two out of the 10 years, FCF has been positive, coming from the last few recent years. Nevertheless, over the long run, it shows Canadian Solar's products are utmost average. Ceteris paribus, Canadian Solar products offer little brand power.

Source: Created by author with data collected from Morning Star

First Solar is a much more consistent and predictable player in the last 10 years. Top-line revenue has grown steadily, but the immediate concern is that both gross and operating margins have deteriorated substantially. It has seen three-year normalized figures at 25% and 3% respectively, which have been declining in the most recent years. The previous year especially recorded over $300mil loss, although largely due to an $838mil asset impairment in connection to the reduction of value in its existing Series 4 modules. According to this SA article, without this one-time charge, First Solar would have been profitable. And most First Solar bulls have been patiently hoping for is the launch of the Series 6 by Q2 of 2018. As for now, First Solar's history is commendable, and FCF margin of over 10% is exceptionally high in a market where solar modules are turning into a commodity. Clearly, there were some competitive advantage and pricing power. Though, the high FCF margin is well reflected in the amount of cash accumulated (we will go into that later). So, overall, better history than Canadian Solar, but currently facing more difficulties as margins deteriorate much faster.

Source: Created by author with data collected from Morning Star

SolarEdge has a shorter track record to work with, but by far the most resilient company operationally. Like the above two companies, revenue has also suffered as of late, but it has maintained gross and operation margins at 24% and 3% on average in the past three years, respectively, and increasing lately to 30% and 15%, respectively. This ability to control cost is translated to inclining FCF margin over the past three years. Impressive feat compared to others.

Source: Created by author with data collected from Morning Star

Operations Management

Canadian Solar generates the highest growth out of the three, and it is not a coincidence it commands the best operating efficiencies. It cycled cash almost twice faster than the other two in 2016. Its strong relationship with debtors, creditors and efficient management of inventory are a huge defense in the difficult years of 2017 and 2018.

Source: Created by author with data collected from Morningstar

Liquidity and Leverage

The same cannot be said about liquidity and leverage position of Canadian Solar. It has $1.5bn in short-term debt and $600mil in long-term debt. Having bad experience with a high leveraged investment such as GulfMark Offshore (NYSEMKT:GLF), I know my judgment of a high leveraged investment is impaired. I might be shy with debts at the moment, but with Canadian Solar, the most worrying part of its leverage situation is the short-term debt, it's large, and a bad quarter or two can really push the company into the danger zones. Its current ratio and quick ratio also strike red flags. Both ratios have been low historically, but the most concerning is the 0.29 quick ratio in the latest quarter. However, it is not as scary when you know that the company also operates numerous solar power plants with resale value of $1.6bil (Q4 2016 presentation). Anyhow, the high leverage position is enough for me to throw the towel.

First Solar and SolarEdge are in much better liquidity condition with very comfortable working capital levels. SolarEdge, especially, is squeaky clean! No debt and an ever-improving quick ratio. First Solar, on the other hand, has in excess of $1.8bil cash for the rainy years (Q4 Earnings Presentation).

Source: Created by author with data collected from Morningstar

Valuation Metrics

Canadian Solar and First Solar look relatively cheap compared to their historical value. P/CF, in particular, looks extremely cheap for Canadian Solar. SolarEdge is commanding the highest valuation metric, and for the right reasons, the top line has been growing strongly, operations and liquidity are also exemplary.

Data as of 03/28/2017

CSIQ

Industry Avg

S&P 500

CSIQ 5Y Avg*

Price/Earnings

4.8

-

21.1

10.4

Price/Book

0.7

0.7

3

1.9

Price/Sales

0.2

0.4

2.1

0.5

Price/Cash Flow

1.7

-

13

8

Dividend Yield %

-

-

2.1

-

Data as of 03/28/2017

FSLR

Industry Avg

S&P 500

FSLR 5Y Avg*

Price/Earnings

-

-

21.1

13.2

Price/Book

0.6

0.7

3

1

Price/Sales

1

0.4

2.1

1.3

Price/Cash Flow

14.1

-

13

22.1

Dividend Yield %

-

-

2.1

-

Data as of 03/28/2017

SEDG

Industry Avg

S&P 500

SEDG 5Y Avg*

Price/Earnings

8.7

-

21.1

-

Price/Book

2.2

0.7

3

-

Price/Sales

1.3

0.4

2.1

-

Price/Cash Flow

9.6

-

13

-

Dividend Yield %

-

-

2.1

-

Source: Morningstar

Insider Trade

First Solar and SolarEdge have seen quite a few insiders sell recently, and the trend shows lack of belief in the outlook of the market and/or the company. It's very difficult to say exactly why. There is also no signification insider ownership; the most was SolarEdge at only 3.6%. At the same time, both companies are highly shorted at 24% and 47%. Meanwhile, Canadian Solar has no recent insider trades, but its share price is at record low in the past three years.

Summary and Market Outlook

The stock market might paint a very depressing picture of the solar energy market as if the market is shrinking. It might be correct; the market is cyclical and may be facing a difficult trough while supply is abundant with fossil fuel prices remaining low. However, renewable energy continues to make positive contribution to the overall utility consumption and the battle to cut global CO2 emissions. At the current consumption, renewables are at a mid-single digit of the total energy used in developed nations, which are committed to increase this to 20% by 2025. This would mean further investments and subsidies in all renewable areas, including solar, wind technologies and energy storage.

As solar energy cost $/watt becomes consistently competitive compared to coal, natural gas and nuclear, consumers will be likely to adopt it even without subsidies. In 2015, two-thirds of all new US generating capacity came from renewables. New employment will also likely to be from the solar industry. The bottom line is the world population and energy needs are still growing, fossil fuels are finite, and the renewable market will grow in the long run. In the medium term, the current influx of cheap solar products from the Far East will subside as a result of better technologies and higher-quality products from the West. These companies will also have plans to build plants in low-cost countries in a bid for lower costs. In fact, Canadian Solar has not imported solar products from China since February 2017 and has been building production facilities in South East Asia, Vietnam, Indonesia and Brazil.

Overall, the short-term threat of China's product is clear for the three companies, however, the US players still remain the leader in many aspects of solar R&D. This leadership has been backed by significant government funding. As Trump administration may or may not take the final decision to cut subsidies, we don't want to speculate anything here. All things considered, it looks like renewables are here to stay.

Coming back to the stock pick, it is a difficult trade-off between growth with leverage and stability with collateral, Canadian Solar vs. First Solar. SolarEdge is evidently a very well-run business, however, with a premium price attached. If none of these stocks suit you, they still warrant a place in your watch list. Wait and see how 2017 plans out and make an entry when these companies achieve their cost objectives, technological goals, capital structure tightening or revenue stabilization. Alternatively, consider the installers, inverters and energy storage. They will certainly benefit from the increasing volume of solar modules, but less susceptible to the fall in price.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.