Solar Energy: Lessons Learned

History is repeating in the solar energy sector. It's December of 2010 and pretty much all of the U.S.-listed solar companies have just crushed the Street estimates for Q3/2010, posted solid beat and raise quarters, and provided a very positive business outlook. Yet all of the stocks have retreated 30-50% from their October highs, so what's going on there?

The solar bears have taken over, spreading fear about rapidly declining ASP's and collapsing margins. Subsidy cuts and the debt crisis in the European Union would lead to lower demand and a possibly massive oversupply in the industry. We saw a bunch of downgrades for solar stocks which were based on those fears, leading to contracting multiples in the sector. But haven't we heard all of that before?

Back in December of 2008 it was the same group of people spreading fear with exactly the same arguments (pricing, oversupply, subsidy cuts) and the financial crisis let the whole sector overshoot to the downside. All of the solar stocks were trading 90-95% below their 52-week highs and you could grab YGE at $3 and TSL at $4. It was all nonsense back then, none of those fears have materialized and 2010 was the best year in history for Chinese solar leaders.

It is true that current module prices will not be sustainable in 2011. Expect ASP's to drop from $1.70-1.80/watt to $1.40, expect gross margins to come down in 2011 as well. But at the same time cost reductions will lead to several poly-based module manufacturers reaching a cost level of sub-$1/watt for the first time next year. Solar energy will become more and more competitive with many companies reaching the highly anticipated "grid parity."

A common sense approach strongly suggests that today's cost leaders are on a steady (albeit bumpy) ride to much higher valuations: Demand for power/electricity will rise, the price of oil and generally fossil energy sources will rise, costs for solar energy will drop to new lows. Most of the world markets are underdeveloped, especially in those emerging economies (Latin America, Asia, Africa) that will see the highest increase in energy consumption, and in the U.S. where the oil lobby still seems to own the country. And then there is of course the environmental aspect. And the growing need to become more independent from imported energy...

Here are three solar stocks that are very attractive at current levels. I also like Yingli Green Energy (YGE) and JA Solar (JASO) here. Personally I would avoid LDK (balance sheet), CSIQ (restatements), and STP (margins). Small players like China Sunergy (CSUN), or even smaller, should be ignored as this is an industry of scale where you can currently buy the leaders at very low multiples. Solarfun (SOLF) looks attractive, but the company is now 49% owned by Koreans, and had a few too many equity raises lately.

The Cost and Margin Leader

Trina Solar (TSL) is the cost leader in the industry. Despite all the talk about disappointing margins, Trina earned a gross margin of 37.6% (Q3/2010) on modules made from in-house wafers and cells - the highest margin among all polysilicon-based vendors. However, as strong demand by far outpaced Trina's internal capacities, the company had to produce modules from purchased cells, which lowered overall gross margin to 31.4%. TSL reported Third Quarter revenue of $508 million, up 37% sequentially, and beating consensus estimates ($420M) by a wide margin. For Q4/2010 the company expects demand to again outpace internal wafer/cell capacity, and it raised guidance well above consensus with overall gross margins expected to be around 30% (35% for modules from self-produced cells). Looking into 2011, Trina indicated that it is already 80% booked for the First Quarter with fixed pricing, and it sees more than adequate demand for the remaining 20%.

Collins Stewart noted on December 1 that "taking into account TSL's income statement and balance sheet efficiency, the company's ROIC was 24.6% in the quarter, a level exceeded by only JinkoSolar (JKS) and First Solar (FSLR) in 3Q10 among the US-listed solar companies."

Hapoalim Securities believes that TSL may be the only solar manufacturer to report positive free cash flow for a full year in 2010: "In contrast to the rest of its peers, we believe TSL has generated positive free cash flow 2010 YTD with operating cash flow of $204M ahead of ~$145M in capex through 3Q10." And Gilford Securities expects that TSL continues to bring its cost down from the current level of $1.08 per watt due to lower polysilicon and further reduction in manufacturing cost in 2011: "There is a fair possibility that cost of $1.00 per watt and lower could be achieved in 1H2011."

And Auriga addresses solar bears by pointing out that "as fear grips the future of the solar industry -- from the generic sell-side perspective -- one can find solace in TSL's balance sheet as 29days inventory and 68days sales are the lowest on record. This is obviously mute if sales collapse as news flow suggests might occur, but even with a worst case sales decline similar to 4Q08/1Q09 and no proactive measures taken by management, inventory never goes higher than 80days."

Analysts are expecting TSL to earn about $3.80 in EPS for 2011 (Collins Stewart: $4.05; Hapoalim: $3.54; Gilford: $3.70; Auriga: $3.84)

Crushed Estimates on Rapidly Increasing Sales

When Jinko Solar (JKS) reported Q3/2010 numbers on November 1, it vaporized the Street consensus at all levels. The company posted $1.75 EPS for the quarter on $215 million in revenue with ASP of $1.81/watt - versus expected $0.95, $148 million and $1.72/w, respectively. Gross margins came in at an excellent 33.5%. Additionally the company is guiding for rising ASP's in Q4/10 and said that it is ahead of schedule in its capacity expansion and expects to reach 600MW by year end with a goal to reach 1GW by the end of 2011. This expansion is supported by the proceeds of a secondary offering that was completed on November 5 when JKS sold 3.5 million shares at $36.

Auriga notes that increased scale is the biggest driver to JinkoSolar's earnings: "In an industry where price declines must be offset by cost reductions, scale offers the best cost opportunity." Analyst estimates for FY 2011 have all been adjusted upwards after the Q3/2010 report, but the uncertainty about ASP's and achieved capacity expansion is reflected in a wide range. Collins Stewart expects FY 2011 of $6.15 and increased their price target to $43. Auriga raised their EPS estimate to $5.05 with a $40 target, and Roth Capital also has a $40 target on projected $6.10 in EPS.

Low Cost Poly and Wafers

The third Chinese solar stock I want to portray today is ReneSola (SOL). Just like its peers, ReneSola crushed Q3/2010 estimates when they reported profits of $0.70 per ADS on revenue of $358 million, well ahead of the consensus at $0.52 and $319 million. And for the Fourth Quarter the company also raised guidance to $340-360 million in revenue, above the old consensus of $310 million. Immediately after the report, Lazard Capital pointed at the robust operating cash flow of $118 million for the quarter and raised their price target to $21.

Auriga came out with a very bullish note on SOL last week. The firm pointed out that ReneSola will benefit "whether poly spot prices stay high (by focusing on wafering operations) or module prices move lower (by sourcing more modules with its low cost poly supply)," and sees the company as the "low-cost polysilicon solar leader at the heart of industry cost reductions." Auriga has an aggressive EPS estimate of $2.56 for FY 2011, well ahead of the $1.90 consensus. But its view is supported by ReneSola's position in the industry where, even with ASP's declining faster than cost reductions could keep up with it, the company will be able to post Y/Y EPS increases on much higher sales. Auriga has a $20 target on the stock and notes that it is currently trading below their 2011 estimated book value and at less than 4x 2011 earnings.

I am adding all three stocks to the China Model Portfolio.