A Second Look at First Solar

The global installed capacity of PV solar is about 250 GW, which represents about 1% of the total electrical power generated. For context, this is smaller than wind (430 GW) and hydro (>1TW). During an average day, solar output peaks in the afternoon, when energy demand is high – a highly desirable feature. It is projected to grow at a healthy (~8%) clip in the foreseeable future, and by 2050 it is estimated that over a quarter of our energy supply will come from the sun.

Overall, it is an industry with secular tailwinds, if you pardon the pun.

History

First Solar (FSLR) is a leader in a fragmented industry. It uses thin films of CdTe to design and manufacture solar modules. In 2008, as oil prices hit $150/barrel, FSLR traded near $300/share. Over the next five years, shares were brutalized, and dropped to ~$10 a pop. From there they surged 7-fold, before getting cut in half again! Currently they trade for a little over $30. FSLR would easily make it to the list of the world’s scariest roller-coasters.

In the glory days of 2006-2009, oil was expensive, and FSLR had delicious EBIT margins of ~30%. Revenue was ballooning at well over 100%/year. FSLR was an industry leader, and could execute at scale. In 2010, it earned nearly $8/share.

Since then, it has seen one disaster after another:

Oil prices dropped precipitously from around $150/barrel to $30. The shale revolution put a ceiling on the price of oil and gas. The shadow cast by the looming expiry of tax incentives (ITC) became darker. According to most estimates, 2016 was a whopper year for solar projects, and the ride is expected to get bumpier. A few solar related bankruptcies (SunEdision) soured sentiment on the entire industry

Perhaps the most catastrophic development has been the flooding of the PV market by cheap Chinese made crystalline silicon wafers. In 2016 alone, module prices declined by 30%. FSLR’s operating margins went down the crapper before stabilizing in the low teens over the last few years. Given the tumult in the industry, it is actually surprising that FSLR has been able to eke out a profit the past few years, without levering up the balance sheet. SunPower, another US firm, for example, seems to be in a worse position from both an operating and balance sheet perspective.

Strengths

FSLR is a leader in a growing, unconsolidated industry. A reasonable case can be made that the malinvestment in cheap silicon will end sooner or later, and pricing will become more rational. This “unsustainablility argument” is not a given, since many Chinese firms are allegedly propped up by uneconomical loans from local banks/government – which means the charade can go on for a while. The longer the madness lasts, the more pain there will be.

Eventually, there will be a day of reckoning.

From past experience, buying the strongest player in an industry temporarily gripped by insanity is a great recipe. FSLR has a strong balance sheet. It has $2B of cash against $400M of long term debt, which corresponds to net cash of about $13/share. It has staying power. The long term secular trend towards more PV solar is not only intact, but may even be more optimistic than previously believed.

By and large, FSLR appears to have competent management. To use a poker metaphor, it has played a bad hand well. They haven’t sacrificed profitability. They haven’t loaded on debt. When it was appropriate FSLR joined with a competitor (SunPower) to create a YieldCo (8point3, in 2015). When the environment changed, they changed their roadmap and jettisoned their S5-series modules.

Weaknesses

The elephant in the room is that solar modules are commodities, which means that you are fighting solely on price. For a while, FSLR had a technological and cost advantage over its peers. It milked that advantage, when it boasted operating margins of >30%. However, that cost advantage has mostly dissipated.

Another disadvantage in a commodity business is that most of the gains in efficiency and reductions in cost are passed on to the customer. From the consumer’s point of view, things are great. From a company’s standpoint, competitive advantages from R&D and improved technology are not durable.

A second headwind is world politics. In the US, for example, the posture has moved against renewables. There has definitely been “climate change” in the attitude to tax policy. In less than 5 years, the solar industry will have to learn to live in a world without subsidies. Luckily, the relentless decline in costs, means that today, in many sunny parts of the world, solar can compete with fossil fuels, when the sun is switched on. The low price of natural gas, which may represent a new normal, may not be bad news, because solar works best with a steadier complementary energy source.

Technological change can be swift. Given the attention being diverted to the problem, it is quite conceivable that there will be a couple of scientific breakthroughs, which will completely neutralize any (small) advantage that FSLR enjoys over the rest of world. This is the big unknowable unknown.

Finally, cadmium telluride is toxic. While chances are small, possible litigation can pose an existential threat, and toss a monkey wrench into FSLR’s best laid plans.

Valuation

With so many sources of uncertainty, it must be well-understood that any number we put up is subject to a huge error bar.

A possible worst scenario may unfold as follows: The development of S6 modules eats away all the excess cash. The delivered product is delayed, and when it finally arrives, it disappoints in a major way. Meanwhile there is a big breakthrough in silicon PV, which makes it the lower cost technology. There is attrition of senior management, and the company’s response is incoherent. Chinese and Indian economies slow down, diminishing the growth prospects of the solar industry. FSLR gets slapped with a class-action lawsuit which alleges its panels caused widespread environmental damage.

There are many ways FSLR can be a zero. I don’t know what the odds are, but they may larger than what many assume. Maybe 10%. 20%? I simply don’t know.

One can also paint a future with an optimistic brush. The S6 modules are a hit, and delivered right on time. Many competitors which don’t have FSLR’s stellar balance sheet can’t keep up and declare bankruptcy. Simultaneously, the Chinese banks decide they have had enough, and stop making uneconomical loans. FSLR is able to capitalize, by snapping up assets at pennies on the dollar. The industry consolidates, and pricing becomes more rational. In the new equilibrium, FSLR emerges in a much stronger position. Given the synergies with gas-fired electricity, it gets snapped up by an energy major at a hefty premium. The chances of this scenario playing out are also non-negligible.

Finally, we can make some quantitative base case estimates, by visualizing what FSLR might look like three years from now.

The revenue in the past couple of years has been around $3.5B, and the 5-year growth rate has been about 7%. Let us assume 5% growth for the next 3 years, so that in 2020 revenue is slightly over $4B. Let us assume that current EBIT margins of 12% persist. In recent years, FSLR’s capex has been about $350m/year – let us assume that $100m of that was for maintenance, while the rest was for growth. Let us assume a tax rate of 18%.

With these assumptions, we get an estimate for normalized earnings as ($4B*.12 -100)(1-0.18) ~$315m. Net income has been over $500m over the past two years – so this number seems reasonable and conservative. Share count has been increasing at about 3.5%; let us suppose that they increase at 4%, and in 3 years we have nearly 117m shares outstanding.

Dividing normalized earnings by the number of shares, I get $2.71/share. We can slap a 15x PE multiple, and add excess cash to arrive at a target price of $43/share in 2020. Here, I assumed that FSLR uses 80% of the net cash on its balance sheet for the development of S6 modules, and only 20% remains in 2020.

With a 12% discount rate, I get a fair price of $30.75, and applying a 20% margin of safety to this number, we get $24.60. At this number ~$25, we would be buying FSLR at around half its tangible book value, even after the planned impairments. Given the conservativeness of our assumptions, buying FSLR at $25 may be an interesting high-risk, high-reward bet.

 

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