For all the gloom and doom weighing on the solar sector nowadays, it’s easy to forget how fast the industry is actually growing and how bright its prospects may really be longer term. And with the dire predictions of many analysts, journalists, and prognosticators casting dark shadows over the outlook for the solar module makers in the face of daunting overcapacity, looming subsidy cuts, and likelihood of an upcoming price war, even the shrewdest investor can quickly lose sight that it is often darkest just before dawn when finding buying opportunities in the stock market.
Choppy Waters Rock All Boats
Any investor who may have rummaged through the rubble of the disastrously performing solar sector year-to-date in search for value early last week would have come out a winner when the bell rung on Wednesday and the solar stocks popped on average about 5% in one trading session even as the S&P 500 fell more than half a percent. The impetus for the rally was unexpected news out of JASO that shipments for 1Q10 were coming in 20% higher than the midpoint of what it had suggested back in February. And while it remains to be seen whether JASO's higher guidance is the canary in the coalmine (environmentalists, please forgive the reference) for the entire industry, the news spread good cheer throughout its peer group which rose in sympathetic hope that it was a good sign for strong industry –wide demand. And with many a trader and short seller sideswiped by the news, it was a healthy reminder how much it can pay off at times to swim upstream in a river flooding over with negativity.
Of course, it makes all the difference in the world buying AMZN after the burst of the tech bubble instead of EK after the digital camera revolution. And the vagaries of how that nuance will affect the solar industry’s growth and profitability certainly came into light on Friday when the group quickly gave up just about half of Wednesday’s gains, dropping more than 3% despite the S&P rising 0.7% on the day to a new post-crisis high.
While the volatility is unnerving to any investor, it especially doesn’t inspire the unwavering confidence of the institutional funds and money managers who have the buying power that really moves stocks. At the same time, it sheds light on the abundance of trading opportunities available in a sector shrouded in as much uncertainty and doubt as the solar sector is.
In fact, this past week’s volatility was merely a microcosm of the sector’s behavior year-to-date. Though last Wednesday’s bounce was certainly welcome to any investor long the stocks, it did little to soften the blow of a relatively dreadful performance for the solar sector so far this year. Through last Friday, the solar module makers as a group (excluding the primarily cell-only makers like JASO and CSUN) are down on average 11% (vs. a 7% rise in the S&P 500 and a 12% gain in the Russell 2000) since the beginning of the year. As the chart below shows, however, all of the losses this year occurred leading into and throughout 4Q09 earnings season.
Even as the solar module companies offered solid 4Q09 earnings reports in which most of them surpassed Street expectations and raised 2010 shipment guidance, investors’ concerns about 2H10 rose to the fore, stifling management’s optimism and forcing the stocks to retrace much of their gains from the end of last year. By mid-March, it seemed every media report on the sector honed in on the forthcoming cut in the German feed-in-tariff, while an array of cautious comments from sell-side analysts fretting about the impact this would have on 2H10 shipments and ASPs, a disparaging Barron’s article, and a swarm of FSLR downgrades deemed any investor willing to go long the sector reckless or ignorant. But just when the drumbeat of pessimism escalated into a steady drone, suddenly the year-to-date bottom was in the rearview mirror.
Like any rally, the bounce in the solar sector began first with an exhaustion of sellers instead of an influx of buyers. But when pessimism crosses paths with data points of unexpected positivity, it quickly adds fuel to the fire. Rumors of a delay in the cut to the German feed-in-tariff raised some eyebrows, Credit Suisse’s 2010 shipment forecast that was almost 50% higher than consensus brought the crowd to its feet, until finally JASO raised its 1Q guidance to the thundering applause from the trading audience last Wednesday. Though the rebound of about 11% on average for the stocks since the apex of negativity following SPWRA’s 3/18 earnings report still leaves the group down 11% for the year (trailing the performance of the S&P 500 by 1800 basis), its unpredictable arrival offered further evidence that negativity and volatility can breed opportunity in an industry that has the tailwind of longer-term secular growth and strong demand.
Dark Clouds on the Horizon Usually Bring Rain…
Of course, no one can escape the pouring rain no matter how sure he is the sun is about to come out. Even the most bullish of solar analysts can’t ignore the dire state the module manufacturing industry finds itself in. With planned production lines north of 20 GW in capacity more than double the midpoint of estimates for 8.5 GW of demand this year, overcapacity is like a dead weight dragging down the outlook for profitability in the solar industry. While this degree of competition fans the flames of concerns about price wars and Chinese dumping, even another 30% drop in ASPs won’t be sufficient to make the economics for solar power installation stand on its own two feet without the generous support of government subsidies. And with budget deficits inflating worldwide from the cost of the financial crisis and rates slowly mounting for utility customers in feed-in-tariff countries, reductions to subsidies in key markets like Germany, Spain, and maybe Italy serve as a perpetual threat to the solar module makers’ subsistence and survivability.
Two parts subsidy cuts mixed with one part price war and a dash of decelerating cost reductions is a recipe for a cantankerous stew of lower revenue growth and margin compression where the only solution is a competitive shakeout that will leave countless dead and many others wounded. In fact, the prognosis has reached such an extreme that comparisons are increasingly being made between the solar module manufacturers and the DRAM industry. The challenges and obstacles facing the solar module makers are not only very real, but they are not going away any time soon.
…but the Sun is Always Shining Behind the Clouds
Nevertheless, even with all of that said, it is just as difficult to deny that the prospects for the solar power industry over the long term are still very bright. Even as overcapacity looms, worldwide demand is not only growing fast but forecasts are increasing. While installations in Germany may face declines in the years ahead, they could be more than made up for by burgeoning markets like the US and China that are potentially much larger. As uneconomic as the cost of solar may be at the moment, manufacturing efficiencies and technological developments are quickly bringing modules down the cost curve. However dark the near-term profitability picture may be, looming even larger behind it is a backdrop of finite fossil fuel sources, oil prices slowly making their way back above $100 a barrel, and a worldwide environmental consciousness that has far outgrown a niche market into the mainstream.
Moreover, unlike many paradoxical business predicaments in which negativity can become self-fulfilling and lead to the proverbial “death spiral,” the outlook for solar power penetration is somewhat bolstered by a win-win dynamic that will ultimately benefit those who survive. Why? Because the more the bearish case for solar power materializes, the cheaper modules become, and the tighter margins compress, ironically the more attractive the solar proposition becomes. The lower solar module ASPs become, the more viable they are as an economic alternative to fossil-fuel based electricity sources, and the more it will feed demand. And while some of the players will certainly not be able to remain cost competitive, they will be pushed out to leave others as even bigger winners. Thus, today’s oversupply situation will inevitably remain a temporary one.
The solar power industry is no DRAM industry. It is being pulled along by secular growth in which long term demand will inevitably overcome near-term overcapacity and in which a dramatic increase in sales volume will overwhelm the relativity of profit margins to drive real growth in absolute profits and in turn a material increase in market capitalization that will reflect the growth of the entire industry.
When the Sun’s Rays Break Through
To be clear, this proclamation is not to be construed as a Solar Manifesto calling for every blind investment in solar stocks today to be profitable somewhere down the line. This will take years to play out and will likely require painful bankruptcies, extensive losses, and a vast destruction of capital in order to get there. Though the bright light at the end of the internet tunnel never stopped shining after the bubble burst in 2000, there were a lot of casualties along the way. In the same vein, it is too early to pick a winner, not to mention a winning technology, or a winning business model within solar. The negative issues affecting solar will take a while to work themselves out. The dire near-term outlook has led to light volume and little investor interest in the sector, so the solar stocks will surely be trapped in the trading range they have been bound within since the end of 2008. And new highs will not be within reach until there is greater clarity or resolution to most—if not all—of these overhangs.
But Traders beware: it’s dangerous to short a sector which offers a secular growth story but for which the consensus outlook is negative. If the longer-term story remains intact, negative sentiment will ultimately prove nothing more than a temporary phenomenon. Periodic data points will come in positive, quiet stocks can quickly come back to life, and short sellers can get run over very quickly.
And Investors stay aware: at some point all the pessimism, all the doubts, and all the concerns rise up in a tempest of negativity that will yield opportunity. Though picking the longer term winners is largely an exercise in futility this early in the game, there will be plenty of near-term data points along the way that will translate into buying opportunities. The key is to gauge when negative sentiment hits such extremes that the next bad news release is widely expected and another downgrade and estimate cut already priced into the stocks. When these points are reached, reversion to the mean is the most likely course and investors can profit from a closing of the gap between overly pessimistic expectations and a more temperate if not positive reality. With sentiment towards solar so deeply negative, the possible positive surprises abound.
As likely as an announcement is from the German Ministry of the Environment about another steep cut in the feed-in-tariff rate next year, equally as likely is the creation of two additional markets launching a new feed-in-tariff scheme. As possible as it is that some of the module makers’ margins disappoint over the next few quarters, just as possible it is it that higher-than-expected shipments drive upside to total operating profits. As much as ASPs can be expected to decline at a steeper pace than the Street expects over the next couple years, so can it be expected that new technological breakthroughs somewhere along the value chain will bring down the installed cost of solar closer to grid parity far quicker than anyone imagines today. Even in the fact of threats of bankruptcies and capital destruction, investors also could be rewarded by opportunities presented by game-changing events like $150 oil, US cap-and-trade legislation, or even something as unexpected as disappointing shale production driving natural gas prices through the roof.
Over the near-term, of course, less momentous events are more likely to surprise. And as last Wednesday’s unexpected bounce revealed, getting a better handle on the solar module makers’ ability to make or miss their guidance will be a critical driver of stock performance. As most analysts and investors already expect relatively strong 1Q10 results on average out of the solar module group, a read into 2010 guidance will be even more critical to the sector’s performance this year.
Part II of this note takes a closer look at the solar module makers’ guidance for the full year 2010 to see how achievable it will be in the context of the broader industry trends and outlook and in the process help investors delve through much of the negative chatter in the hopes of finding the next potential surprise.
Disclosure: No Positions
Disclosure: No Positions