Chinese Solar Companies - Analysis

Now that we have the third quarter results for all the Chinese solar companies, let's have a closer look at the performance, numbers and developments in the industry.

Third Quarter 2011 Results:

Revenue

For our group of ten companies, third quarter revenue declined both sequentially and year-over-year. Revenue for the traditionally much stronger third quarter declined on average by 9.6% from the second quarter of 2011. Only four companies - Canadian Solar (CSIQ), China Sunergy (CSUN), Suntech Power Holdings (STP) and Yingli Green Energy (YGE) could keep the same level from last quarter, while three companies posted hefty declines of 20% or more: Hanwha Solarone (HSOL), JinkoSolar (JKS), and ReneSola (SOL).

Those are disastrous numbers, especially if compared to what happened just one year ago. For the third quarter of 2010, ReneSola posted sequential revenue growth of 41.3%, compared to a revenue decline of 24.2% this year. For Trina Solar (TSL) those numbers are 37.1% growth versus 16.8% decline, but we can pick any name in the group to illustrate the unusual downtown in the traditionally very busy third quarter this year.

If we compare the Q3 revenue numbers with those of 2010, the picture looks slightly better with a year-over-year decline of "just" 3.8%. Most of this decline comes from the primarily upstream (solar wafers and cells) companies in the group: LDK Solar (LDK), ReneSola, and JA Solar (JASO), which on average lost 36.4% of their 2010 revenue. If we take those three out of the group, the rest - primarily module producers - managed to post year-over-year revenue growth of 10.2%.

The big exception among the downstream Chinese solars is Hanwha Solarone (HSOL) with year-over-year revenue decline of 34.4%. This might be a huge warning sign, as five out of seven of HSOL's direct peers managed to grow their revenue over the same period. Please review the numbers for all ten companies in the table above.

POSITIVE: CSIQ, CSUN, STP, YGE
NEGATIVE: HSOL, JASO, JKS, LDK, SOL, TSL

Gross Profit and Margins

In the third quarter of 2010 all ten of our Chinese solar companies posted double digit gross margins, ranging from the high teens to well into the 30 percent area. Just twelve months later those margins have collapsed for 90% of the group, with five companies reporting negative gross margins. As to be expected, the smallest module vendors, China Sunergy and Hanwha Solarone, suffered the most, as the solar industry is - and will always be - an industry of scale.

Only three of the ten companies still posted worthwhile gross margins last quarter, the market and cost leaders among the Chinese module producers: Trina Solar, Yingli Green, and Suntech Power. Especially STP is standing out here. The company moved from last to first place in the group, as its margins only moderately declined, from 17.9% in 2010 to 13.3% this year.

Those numbers stand in stark contrast to two other downstream companies. JinkoSolar's margins collapsed from 25.4% in Q2/2011 - the highest of the group at that time - to 3.7% in just three months, the direct effect of a 21.4% sequential decline in revenue. And while Canadian Solar managed to actually grow revenue sequentially, its gross margins (2.4%) are no longer acceptable which suggests that the company's strategy was to generate revenue at all cost.

POSITIVE: STP, TSL, YGE
NEGATIVE: CSIQ, CSUN, HSOL, JASO, JKS, LDK, SOL

Net Income and EPS

One year ago, all ten companies in our group were nicely profitable with operating margins ranging from 8.4% (STP) to 26.4% (JKS) and positive earnings per share. In Q2/2011, half of the group was already posting losses, and for the third quarter only Yingli Green Energy managed to break even on an operating level. These are disastrous results for the industry, especially if we consider that half of the group posted significant year-over-year revenue growth.

All ten companies were forced to write off some inventory which impacted the bottom line. However, if we adjust reported net income for these inventory write-downs, nine out of ten companies have still reported negative EPS. Only Yingli Green Energy reported positive numbers on an adjusted basis with $0.08 per share excluding write-downs and $0.14 per share as reported by the company on a non-GAAP basis. Yingli's business development trends look far better than those reported by its direct peers.

POSITIVE: YGE
NEGATIVE: CSIQ, CSUN, HSOL, JASO, JKS, LDK, SOL, STP, TSL

Company Guidance Revisions: (since June 30, 2011)

Official company guidance and what the company says about its business prospects can be very telling about how well management understands its market. Assumed management actually intends to tell the truth and give a realistic business outlook. If they have been utterly wrong several times in the past, why should we put too much weight on their current outlook?

We have evaluated the officially published FY2011 guidance for all ten Chinese solar companies, and the only one that actually raised its guidance at some point this year was LDK Solar. In January, LDK raised its full year revenue outlook by an astonishing $600 million and guided for gross margins in the 23.0% to 28.0% range. In mid-March Chairman Peng addressed the investment world with "we have made great strides in positioning LDK Solar to take advantage of the growth in the global PV industry. We remain excited about the multiple growth drivers we see for our business and believe we are well positioned for success." LDK reiterated its revenue guidance and raised the low end for gross margins by another percentage point.

Management kept this guidance until well into the third quarter when it was already very obvious that nothing of this will materialize. And for the third quarter the company reported a 30% decline in revenue with negative gross margins. Consequently, LDK's current FY 2011 guidance has been lowered by almost 40% from levels that were still official company outlook in August.

While the industry downturn forced nine of our ten companies to lower FY2011 guidance in the second half of this year, it is important to note that several names have not lost their credibility and have given a more or less realistic outlook at the beginning of the year. The only one that kept its original shipment guidance unchanged is Canadian Solar (CSIQ), while both Suntech Power and Yingli have lowered it only moderately. Those three are also the largest module vendors, based on Q3 revenue, while the small players in the group, CSUN and JASO, were forced to slash their guidance by at least 25%.

POSITIVE: CSIQ, STP, YGE
NEGATIVE: CSUN, HSOL, JASO, LDK, SOL

Debt Situation:
Net Debt (Debt): Total Liabilities - Total Current Assets (ex Inventories)
Debt to Equity (D/E): Total Liabilities - Total Shareholders' Equity

The debt situation is rapidly deteriorating for all 10 companies, and as the outlook for the industry is very negative for at least another 2-3 quarters, this is not going to become even worse. Further EPS losses are very likely for Q4/2011 to Q2/2012, probably even into the third quarter next year. While Trina Solar (low net debt) and Yingli Green Energy (large cash position) both look safe at this point, its huge debt burden could turn out to be a bigger problem for Suntech Power.

For LDK Solar the picture looks very bleak. With negative gross profit, a low cash position and rapidly deteriorating revenue, LDK is already running low on working capital, and if we consider the interest expense on its gigantic debt load something will have to happen next year to resolve this situation. If the company wants to survive this downturn, a debt to equity swap seems unavoidable, which means there is very little value in LDK's stock.

POSITIVE: JASO, TSL
NEGATIVE: CSUN, CSIQ, JKS, LDK, STP

Summary:

Third quarter earnings results for our group of 10 Chinese solar companies were generally weak, with only YGE (and to a lesser degree STP) providing some positive headlines. End markets are supposed to remain challenging for at least another 2-3 quarters with an unresolved debt crisis in Europe, massive overcapacity issues in the industry, high inventory levels, and ASP's rapidly declining. Despite collapsing end prices there was no meaningful demand uptick in the traditionally strong third quarter, and the near future brings us unfavourable weather conditions for all of the industry's strongest markets.

All signs point to a period of painful consolidation in the industry that is coming much earlier than anticipated. The weak players will be shaken out and eventually the industry will turn into oligopoly where only a handful of players will dominate the market. Third quarter results are a good indication of who will make it and who might eventually vanish over the next few years. With no positive catalysts to be expected over the next few months, it is probably to early to jump back into the sector, but the survivors will most likely come out stronger than before, in an industry that is here to stay.

Based on this analysis of business metrics and third quarter results, here is my take on the survival chances for all ten Chinese solar companies:

GOOD: YGE
NEUTRAL: CSIQ, STP, TSL
BAD: CSUN, HSOL, JASO, JKS, SOL
VERY BAD: LDK

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.