August 1, 2019 marked the third straight earnings miss by First Solar (FSLR). The average miss is over $0.28 in EPS so these have not been small rounding errors. In addition, revenues have also missed estimates for five straight quarters. The average revenue miss over the past five quarters was by over 16% below Wall Street expectations. Yet despite such a bad recent track record by FSLR's management, Q2 2019 earnings did provide operating metrics that so far support the company's manufacturing cost targets for its new Series 6 product line.
First Solar's Lack Of Transparency
To be fair to Wall Street analysts, earnings misses aren't entirely on the analysts covering First Solar. Since coming out of the Financial Crisis of 2008, First Solar has slowly made it a policy to disclose progressively less and less information with each earnings report. While some information such as wholesale average selling prices [ASP] arguably should be kept private, other operating metrics shouldn't qualify for non-disclosure due to 'competitive' reasons.
Q4 2013 was the last quarter First Solar disclosed its manufacturing production costs. Q3 2018 was the last quarter First Solar disclosed the average efficiency for its solar modules. I find it difficult to argue how disclosing the average efficiency for manufactured solar modules compromises any production secrets. In fact the only explanation I can think of for First Solar to stop disclosing efficiency metrics is because it had shown almost no improvement over six straight quarters.
In contrast Jinko Solar (JKS) up until a year ago gave extremely detailed information on their operating metrics including production costs as the table below shows. Although Jinko Solar stopped disclosing manufacturing costs in plain black and white in the past four quarters, the company still gave enough information in its earnings reports and annual report to derive these operational metrics to a fair degree of accuracy. Another major First Solar competitor, Canadian Solar (CSIQ), even flat out disclosed its quarterly module ASPs.
(Example of Jinko Solar's manufacturing cost transparency taken from their Q1 2018 earnings presentation.)
I just find it ironic that 'in America we trust' companies like First Solar and Sunpower (SPWR) have been extremely opaque while 'can't trust those Chinese companies' like Jinko Solar and Canadian Solar (only Canadian by name) have been nothing but transparent in good times and bad. It is this transparency that has been important for investors to determine the long term viability of the solar industry.
What First Solar's Second Quarter 2019 Earnings Report Did Reveal
First I do want to make a point clear for all current and potential First Solar investors - quarterly results don't mean much as long as annual figures are inline. Over half of First Solar's revenues are from solar project sales and due to their large size could take longer than a quarter to close. The exact timing of revenue recognition could cause one quarter to blow out estimates then completely miss the next quarter. That said, the magnitude of earnings surprises could be lowered greatly if the company was more transparent with its other operating metrics.
In its Q2 2019 earnings conference call, First Solar stated system segment gross margin was 18% and module segment gross margin was 5%. This is a big improvement from 5% and -13% gross margin for system and module segments respectively. The 18% turnaround in module segment gross margin gives significant insight on how manufacturing costs for First Solar's Series 6 is tracking.
Based on my calculations, blended module production costs would need to drop by around $0.05/watt to achieve this magnitude of a gross margin turnaround. This is based on $0.385/watt stable module ASPs in the first half of 2019 and excludes the stated ramp costs of $36m in Q1 and $18m in Q2 2019. This ASP assumption is higher than my original $0.36/watt estimates for 2019 made prior to the second quarter results and is based on First Solar's updated slightly higher 2019 gross margin guidance.
Since First Solar's Series 4 has been in constant production in recent years, the manufacturing costs should also be constant. This implies the company's new Series 6 manufacturing costs dropped by more than $0.05/watt during the quarter. Based on the company's production levels of 1137MW in Q1 and 1376MW in Q2 and assuming legacy Series 4 has been operating near full utilization run rate of 500MW quarterly, I estimate Series 6 costs dropped by roughly $0.08/watt. Again this figure is exclusive of ramp costs since the goal is to estimate the normalized production cost level. Including ramp costs, I estimate Series 6 production costs dropped by 24-25% and inline with the company's 25% Q1-Q2 manufacturing cost drop estimated in Q4 2018.
Second Half 2019
First Solar's first and second quarter earnings misses combined with the incremental increases in fiscal 2019 guidance implies second half 2019 numbers will be significantly above annual median levels. If realized, the company's gross margin revision from 18-19% to 18.5-19.5% will have a very significant impact on manufacturing cost levels for its Series 6 production in the second half of this year.
In the first half of 2019, First Solar posted revenues of $1.12 billion with a gross margin of 6.92%. At the midpoint of First Solar's 2019 revenue guidance, second half revenues should be around $2.48 billion. Thus to reach the increased midpoint gross margin guidance for 2019, second half gross margin would need to average 24.4%.
Since revenue from solar system sales usually reflect projects started at least a quarter prior, gross margin would not reflect current cost levels. Thus with second half gross margin expanding significantly compared to the first half, system segment gross margin should be lower than blended gross margin. Management essentially backed this during their 2019 guidance conference call when they stated system gross margin would range between 15-20% while blended gross margin would range 20-21%.
If the company delivers on their guidance, module segment gross margin would expand dramatically from 5% in second quarter to potentially over 25% in the second half. With Series 4 production costs largely fixed, Series 6 gross margin would need be higher than 25% to achieve this magnitude of margin expansion. I estimate Series 6 gross margin would need to be well over 35% to achieve a blended module segment gross margin of 25%. With stable module ASPs, Series 6 production costs should drop below $0.25/watt sometime in the second half of 2019.
First Solar's Revenue Guidance
While potentially aggressive to some, First Solar's margin guidance could still be rationalized if the company's new Series 6 product achieves targeted manufacturing cost levels set at the announcement of the product line. From my perspective, the company's revenue guidance is a little harder to reconcile based on known industry average selling prices for both solar projects as well as component modules.
With utility projects averaging less than $1.15/watt in the past couple of years, it's unlikely First Solar's project sales would average higher than $1.15/watt. The most important factor for utility scale projects is return on investment therefore costs are paramount. While bankability is a critical factor, First Solar is only one of many Tier 1 brands so in my opinion I do not believe they could get any premium factor for utility scale projects unlike residential-centric peers like Sunpower who could more easily sell brand name over costs to an individual home owner.
At a 5.6 GW median shipment guidance for 2019 and preliminary module shipments up to 4 GW, system segment shipments would range around 1.6-1.7 GW. That is at most $1.96 billion in system segment revenues and leaves around $1.64 billion in module segment sales using the midpoint revenue guidance. This suggests module ASPs of $0.41/watt at 4 GW shipments or $0.42/watt at 3.9 GW shipments.
Not only are these module ASPs high compared to current industry levels but they are above management's own suggested levels of $0.36/watt made during the company's Q1 2019 earnings conference call. The other problem with assuming high module ASPs is that it would imply higher manufacturing costs based on first and second quarter reported results. Namely Series 6 production costs would have to start off well above $0.45/watt in Q1 2019 and would not reach the 'low 20s/watt' target after a 40% manufacturing cost reduction after streamlining the production process.
As noted above I assumed first half module ASPs of $0.385/watt and estimate second half module ASPs would stay fairly stable at $0.38/watt. It represents a midpoint compromise between management indications and figures required to match the company's full year revenue guidance. At this module ASP level and assuming Series 4 production costs stay constant, First Solar's Series 6 manufacturing costs could drop to around $0.23/watt by the end of this year.
The reason why I concentrated on discussing Series 6 costs more than earnings is because this manufacturing metric is critical in determining First Solar's future profitability beyond this year. As I noted in my previous article, First Solar has suffered from a long standing competitive disadvantage ever since the collapse of polysilicon prices. Silicon based solar cost levels had dropped by so much it caused First Solar to cut short its Series 4 plans, scrap its Series 5 product entirely, and take hundreds of millions in restructuring charges. Without a lower cost manufacturing profile, First Solar would eventually be completely marginalized within the industry.
So far, results from the second quarter have been promising and if 2019 annual guidance can be achieved, First Solar would be in a very good position to build on its 2019 turnaround next year. While I personally don't believe First Solar deserves any multiple premium over other solar companies trading at much lower valuations, at 17x current 2020 Wall Street average EPS estimates of $3.69, the stock is not expensive either especially when many sectors in today's stock market are trading at much higher valuations compared their historical average. Of course the key is for First Solar to hit its annual guidance. Based on history, I take everything from First Solar with a grain of salt.
Disclosure: I am/we are long CSIQ, JKS. 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.