After the failure of the federally-supported company, Solyndra, shares of First Solar (FSLR) have been beaten down harshly. By now, you’ve probably heard that Solyndra received over half a billion dollars in federal loans, and thereafter went bankrupt. It looks possible that First Solar, which is scheduled to possibly receive government loan assistance for its next major projects, could have their funding stripped away by a reactionary Congress. Management has noted this would “materially affect earnings.”
So why is the market so negative on the solar industry? It hasn’t been a sudden change, but only recently has the trend come to like. There are a few things to like about the solar industry. For one, it’s growing rapidly. According to the Solar Energies Industry Association, US demand alone has grown 69% year to date and expects to achieve a growth rate of nearly 100%. Although the numbers are unclear, China is also growing at a tepid pace. The rest of the emerging world also shows a healthy appetite for this clean energy, and global pollution mandates will create more demand for solar energy, regardless if the market really wants it.
Additionally, a company like First Solar receives low-cost government backed loans to keep costs low. With the most advanced technology, First Solar is the lowest cost American producer at $0.99/watt (common industry metric). It is also the largest, with facilities in Australia, Europe, North America and Asia.
However, the industry has plenty of downside, the biggest being the heavy government investment and subsidies involved. During good macroeconomic conditions, the US government is willing to invest more in “green energies” to meet pollution target mandates and create jobs. However, the US, Italy, and to a lesser extent, Germany, are concerned with global economic conditions, with Italy specifically, and likely the United States, pursuing austerity measures that will cut subsidies to industries like solar energy. Additionally, this austerity in the developed world could put a drag on developing economies’ growth, which could lead to lower fossil fuel prices. This could harm the incentive to install solar energy.
Furthermore, these massive subsidies vary by nation, and thus far appear to give Chinese companies a low-cost advantage, in spite of having lower quality technology. The Department of Energy blames these massive subsidies for the United States transitioning from the world’s largest solar supplier in the 1990’s to only producing 7% of the global supply today.
The effects on First Solar could be absolutely devastating. In the second quarter, we saw gross margins fall by 1,200 basis points year-over-year and over 900 basis points sequentially. SG&A also swelled to over 16% of sales. With substantial political risks in the United States and Europe, we think earnings will be significiantly lower than what the company guided. We wouldn’t be surprised to see revenues underperform expectations and earnings per share actually fall for the year.
In our scenarios, we see shares of First Solar worth about $53 per share on the high end of our fair value range at this time. Even with increasing revenues for the fourth quarter expected to double, we don’t think they will be able to maintain their excess gross margins and high returns on invested capital. Ultimately, given the substantial risks involved that are completely out of the company’s control, we think investors may be best served looking at cheap out of the money put options or avoiding the stock altogether. Even if it is the best in the industry, it doesn’t look like the biggest consumers of solar energy will be increasing spending any time soon, and that the Chinese have a labor-cost advantage that could take decades to erode.
All that said, the company still has cash hoard of over $300 million, is the technological innovator in the industry, and management seems very confident in future prospects. Ultimately, down the road, and after some industry consolidation allows for better pricing, First Solar could be an interesting investment. However, we’re looking at it as a put-option candidate in the portfolio of our Best Ideas Newsletter.