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InSite Newsletter, July 2009

"God is in the details."
Ludwig Mies van der Rohe (1886-1969)

Our last newsletter tracked the performance of the optical telecom component sector as it went through the bursting of the telecom bubble. Approaching a decade since the telecom bubble burst, the sector still struggles, and continues to frustrate investors, management teams, and thousands of employees. Within our last newsletter, we shared with you our intention to analyze the ecosystem around telecom. However, we received much more feedback requesting analysis of an industry that is currently experiencing difficulties: the solar cell industry.

Investors have many serious concerns with the solar industry, including

  1. The solar business is heavily subsidized -- without subsidies could it collapse
  2. The government subsidies will end due to financial spending constraints
  3. The solar industry competes with many different types of alternative energies
  4. The solar industry does not have sufficient cash flow to repay its debt

This newsletter works to examine these issues by focusing upon the financial performance of this industry by comparing it to the telecom industry, in both times of strong growth and rapid declines. This review exposes surprising, and fundamental, differences, leading to strong conclusions concerning the forward trajectory of the solar industry. Our next newsletter will examine the ecosystem surrounding the solar cell industry.

The key question: Is the solar industry an area suitable for further investment?

The Basics

A solar cell, or photovoltaic cell, is a device that converts light into electricity. A solar cell may be manufactured using many different semiconductor materials, each with trade?offs in cost, performance, and appearance. The industry has been around for several decades; however, it has only shown strong growth in the 21st century. This complementary report does not consider the different technologies or the drivers of the growth of the industry; rather it focuses solely upon the financial performance of the public solar cell industry, as compared to the public component vendors in the optical telecom space.

Approach

The public solar companies we analyzed are makers of solar cells and solar cell modules. These companies are dispersed throughout the world, in Europe, North America and China. The companies include: Canadian Solar, China Sunergy, Evergreen Solar, First Solar, GT Solar International, JA Solar, LDK Solar, ReneSola, Solarfun Power, SunPower, SunTech Power, Trina Solar, and Yingli Green Energy.

Our software system now allows the analysis of foreign financial documents. As before, we begin the analysis by extracting, standardizing, and then combining the financial statements of these companies, calling them the "Solar Group" (SG). This provides a picture of the overall health of the industry. Then we compare the SG to the "Telecom Group" (TG) using a wide variety of metrics. The members of the TG are listed here.

All figures are based upon Generally Accepted Accounting Principles (GAAP) numbers, or their international equivalents, with no pro-forma results considered. A full discussion of why pro-forma numbers are excluded may be found here.

Taxes, Credits, and Solar

Every analyst we have spoken with and each panel we've heard focuses on the fact that the alternative energy business, and solar in particular, receives financial support from governments. The conventional wisdom is that without this aid the industry would simply collapse.

This viewpoint may miss the larger point. The support of this industry is occurring because governments are beginning to respond to the perceived threat of global warming and the desire to more directly control their energy supplies.

Here are two different viewpoints of global warming.

Rep. Paul Broun (R-GA) stated on the House Floor  "Scientists all over this world say that the idea of human induced global climate change is one of the greatest hoaxes perpetrated out of the scientific community."

 Paul Krugman, a Nobel Laureate in Economics, stated this about climate change "In other words, we're facing a clear and present danger to our way of life, perhaps even to civilization itself. How can anyone justify failing to act?"

These statements very nicely frame the issue of subsidies for the solar industry.

If Broun is right, we'll find that the planet just starts cooling off. There will be no need for subsidies, and the solar industry will collapse. If Krugman is correct, the cost of using carbon-based fuels relative to carbon-neutral or clean energy sources will go higher, and higher, and higher as society comes to comprehend the true cost of climate change. This will mean that governments will take increasingly bolder steps to slow the usage of fossil fuels. As a result, the cost of carbon-based fuels will substantially increase over time, making solar and alternative energies more economically viable alternatives.

Our belief is that global warming is real, that it will prove to be enormously costly, and that this will result in increasing economic leverage for the solar industry relative to carbon-based energy.

Key point: Economic advantages for the solar industry will increase over time.

Financial Performance Overview

To help the reader visualize the overall performance of the SG, Figure 1 shows the evolution of key metrics for the time-period 2004-2008.

Key Solar Cell Industry Metrics

Growth

The growth drivers of the two industries, TG and SG, are considered obvious. For the TG, the constancy of Internet usage growth, with transported data growing at ~50% per year, drives continual equipment deployment. For the SG, the long-term growth driver is a continuing improvement in the economics of solar energy, as compared to traditional fossil fuels. Stated a little differently, both the telecom and solar groups have good growth prospects, as long as Internet usage keeps increasing and the use of fossil fuels becomes increasingly expensive over time, respectively.

We begin the discussion by examining the revenue of the groups as they go through a revenue peak. The revenue of the two industries is shown below in Figure 2. The peak revenue of the SG is roughly twice that of the TG.

To better examine the shape of the revenue curves, the quarterly revenue values are normalized and plotted in Figure 3. The shape of the curves during times of growth and the initial fall are strikingly similar.

Key point: Both industries demonstrate that in times of rapidly increasing demand, product output and revenue can rise very quickly.

Key point: In times of low demand, revenue contraction is painful and rapid.

Quarterly revenue comparison

Normalized quarterly revenue comparison

Profitability

The gross margins during the ramp period were ~25% and ~50% for the SG and TG, respectively. However, the behavior of the TG following the peak revenue quarter was not encouraging, with negative gross margin of -17%, a drop exceeding 60 points in a single quarter, followed by a long and unsteady increase of gross margin. Six years after the bubble bursting, the industry has achieved gross margin performance of ~30%.

The SG has performed better in this downturn. The first quarter of the downturn saw gross margin drop by 23 points, to 2%, but rebound in the second quarter, on falling revenue, to 17%, only 8 points beneath the margin performance seen in the robust growth phase. Within the SG, several companies showed excellent corporate responsiveness to this changing business environment, suggesting that with proper structure and management, a solar cell company can react very well to changing business environments.

Key point: The cost structure of the SG responds better than the TG in situations of falling revenue.

Quarterly Gross Margin Comparison

The operational infrastructure is much leaner in the SG, with total operational expenses (OpEx), as a percentage of revenue, on the order of 10% of revenue. By contrast, the average OpEx of the TG between 2005?2008 was over 50% of revenue.

The conversion of R&D dollars into revenue is much more efficient in SG, where R&D spending is on the order of 2%, versus 15% in the TG.

Key point: The SG has much leaner operational spending than the TG, allowing it to thrive on modest gross margins.

Even in this deep recession, the SG is only about 10 points from an ROS figure of 10%. Given a normalization of solar demand, acceptable profitability appears very achievable without structural changes in the industry.

In contrast, years into a slow recovery, the TG is still roughly 25 points away from an ROS figure of 10%. That type of gap cannot be covered without structural changes to the constituent companies and the ecosystem surrounding the companies.

Key point: The solar industry can recover to acceptable profitability without undue consolidation.

The most striking difference between these two industries is that the SG makes money and the TG does not. The SG was profitable for 10 consecutive quarters prior to the revenue peak, earning $1.6B in net profit on $12B of revenue. By contrast, in the 10 quarters of strong revenue growth prior to the telecom peak, the TG lost $2.2B on $5.4B of revenue.

Key point: It is the norm of the SG to be profitable.

Quarterly Net Income/Revenue Comparison

Value Creation

The value creation record, as measured by the combination of retained earnings and shareholder equity on the balance sheet, is very different for the two industries. The TG has a very poor record in this regard driven by steady operational losses coupled with very disastrous M&A activities. In contrast, the SG has steadily improved the equity section of the balance sheet through the accumulation of a steady stream of profits and prudent use of capital funds raised.

The record of M&A activity in the TG has not been kind to investors or employees. At the peak of the telecom bubble, 80% of the assets of the TG were intangible, placed onto balance sheets by paying premiums far in excess of the real assets of either of the companies in the merger. By contrast, M&A activity in the SG has been much more modest, with very small goodwill or other intangible assets placed onto the balance sheet. Much of the loss of the TG is the write-downs of acquisitions that did not meet the financial expectations of the management teams.

As mentioned, the SG has not placed a great deal of goodwill or intangible assets on their balance sheets, meaning that potential write-downs of intangible assets are also very limited.

Key point: The SG will not surprise investors with large losses due to poor acquisitions.

From an operational standpoint, one reality of an industry with high levels of M&A activity is the cost and distraction required for the ultimate rationalization and integration of all of the acquisitions. The TG underwent years of rationalization, and during that time, the performance of the group was quite poor. Since the SG has not had nearly as much M&A activity, it does not have to face the challenge of simultaneously integrating businesses and adapting to the tough economic realities that this recession presents.

Key point: The SG does not currently face substantial business integration challenges.

Liquidity

The liquidity of the SG has deteriorated substantially over the past year as it goes through this industry downturn. In contrast, the TG has had excellent liquidity through multiple business cycles.

Current Ratio and Acid Test for Solar Sector

This liquidity stress can also be seen in examining the details of current liabilities. Over the past year (3/31/08 to 3/31/09), the amount that the SG owes its suppliers has increased from ~$660M to ~$1.650B on roughly flat revenue. On average, suppliers to the SG are now waiting about three months to be paid, up from the pre-bubble industry norm of a little over a month.

Indeed, in this difficult period, the SG is slowing down payments to vendors at the same time that the customers of SG are pushing out paying their bills. This sluggish cash conversion cycle hurts the SG because companies have many costs, including items such as rent, taxes, and wages that cannot be pushed out while customers under stress can produce virtually limitless, and creative, reasons to not pay their bills.

While the industry has good long-term growth prospects, if the liquidity issue worsens it will either eliminate companies with weak balance sheets or lead companies to dilutive or expensive methods of raising capital. From the standpoint of the health of the overall industry, it is much better for poorly performing companies to exit the industry or merge with companies with stronger balance sheets. Indeed, if this recession-driven liquidity crisis leads to "creative" financing to keep non-competitive companies in operation, we would see this as a reason to become extremely cautious investing in the sector.

Liquidity problems force tough operational decisions. The TG, with excellent liquidity, has been able to defer steps to cut costs.

Key point: The SG is experiencing liquidity problems. If the industry adopts a position of raising capital to fund noncompetitive businesses, it should be seen as a cautionary signal to investors.

Asset Quality and Debt

As mentioned previously, the SG has very little goodwill and intangible assets on their balance sheets. The number of days sales outstanding (DSO) is moving up, as customers are pushing out payments for products. This does exacerbate liquidity problems; however, it is clearly recession related and not an indicator of larger problems.

This is a high fixed-cost business, with ~$11B of long-term assets. If the industry downturn continues, these assets will be impaired leading to future losses. Exposure to underutilization of assets is a serious danger for any high fixed cost business. Given the general expectation of returning revenue growth, this risk appears minor.

The industry has a moderate debt level, with a leverage ratio (assets/total equity) of 1.3. Although this debt level is moderate, it should be of concern given the deteriorating liquidity situation of the industry. In a prolonged downturn, or a recovery that does not include real cash generation, this long-term debt, currently at ~$3B, will become problematic for the weaker companies in the sector.

Key point: The SG has a moderate debt level, with some individual companies much more leveraged. This debt, in combination with waning liquidity, is a very serious issue for some companies in this sector.

Conclusion

A collection of key solar cell companies is studied as a group

  • Economic advantages for the SG will increase over time.
  • The SG has shown strong revenue growth.
  • The overall profitability of the SG is good.
    • In the ten quarters prior to the revenue peak, the SG had net profits.
    • The SG has responded well to the downturn and generated a small operational profit in the quarter ending 3/31/09
  • Operational expenses are quite lean and are inline with narrow gross margins
    • Research and Development of ~2%
    • Total operational expenses of ~10%
  • The liquidity of the industry is degrading, which may force out weaker players or encourage marginal players to seek financing on expensive terms.
  • The debt level of the industry may prove problematic for weaker players without normalization of demand.

Cheers,

The InSite Team

For additional detail concerning our modeling of telecom and solar industries, individual company comparisons to their peers, or for details on the further sector analytic capabilities of InSite, please contact us here.

This document contains thoughts and opinions concerning alternative business practices. The recommendations contained within this document may not be appropriate for every business, and InSite Partners, LLC is not responsible for any detrimental effects or results from the use of these ideas and suggestions.

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