First Solar Falls Again

First Solar (FSLR), a company we have been bearish on, came out with downwardly revised fourth quarter and 2012 guidance this week, sending shares down nearly 20%. Things have been a mess at First Solar. Solar overcapacity is still tremendous, and thanks to government subsidies, it’s nearly impossible for any US company to be the low-cost provider.

Our previous fair value on the stock was $31 per share, assuming inflation-like growth in 2012 and earnings of $4.76 per share, far lower than $7.42 Street consensus. It’s been very clear to us that the solar industry is going through an almost textbook economic cycle, and not the part that’s good for generating excess returns on invested capital.

At first, a few big companies ruled everything, made fat profits as oil and natural gas soared in price. However, cheaper, more efficient competitors have rushed in–many in China operating at a loss–to steal the fundamental momentum from the solar companies, like First Solar, that benefited so greatly from a technology edge. The firm simply cannot produce their products as cheaply, or with the same efficiency, as competitors. Management refuses to acknowledge that its production costs are still higher than more efficient technology across the industry, and instead insists the company will close the gap by 2015 (perhaps…but by then it might be too late).

The sale of a power plant to Berkshire-owned MidAmerican Energy Holdings was an initial sign of distress. Without profitable operations, the company will have to pawn off productive assets to stay alive. Additionally, without significant industry consolidation, or a completely unexpected and unprecedented change of heart from the Chinese government, American solar companies’ profits will fall over the near-term.

In light of the recent guidance revision, we are cutting our earnings estimates to $3.66 a share for 2012, due to falling revenues and compressing margins. As a result, we now think shares are worth $22 per share. Even though management guided to $3.75 to $4.25, we think austerity measures in Europe, uncertainty in the US political sphere make forecasting even more difficult. As well, a potential recession throughout the EU coupled with a potential slow-down in China, may lead to sustained lower natural gas and oil prices, weakening the demand for solar energy.

We will be keeping a close eye on the company, and, if our fears play out, we expect the downside of our fair value range to be the most likely outcome. Further, we are staying away from long positions in any solar company at the moment. The industry economics are terrible, and appear to be deteriorating. For investors looking to add exposure to the energy sector, we point to Helmerich & Payne (HP) as an idea.