Re-Set or Game Over?

The solar industry, like many young industries, depends on substantial government subsidies to fuel growth and profitability. Weaning the industry off these generous subsidies, though, is proving to be a bumpy process.

Germany has long been at the core of the solar industry’s growth, driving installations with generous Feed-In Tariff schemes (FIT) that reward project developers who generate solar electricity. The country’s FIT structure incorporates a yearly decline in subsidies, designed to spur technological innovation and cost cutting in the solar industry. This is critical to keep in mind since Germany accounts for roughly 40 percent of the industry’s consumption, and each of the major publicly traded solar companies, including, First Solar (FSLR), SunPower (SPWRA), Trina Solar (TSL), and Suntech (STP) derive at least a third of their sales from Germany. First Solar still derives over 70 percent of its revenue from Germany.

As Germany’s subsidy declined eight percent in 2009 and 2010, the cost of solar panels was cut in half over the past year, driven in no small part by plunging raw materials costs. Selling prices have fallen at the same rate, now below $2.00 per watt versus over $4.00 at this time last year. With a new political party in control in Germany, the government decided that strengthening solar demand, if left unchecked, would put too much financial pressure on the country.

On January 20, 2010, the government proposed the following adjustments to the FIT:

- A 15 percent one-time reduction to rooftop systems rates effective April 1, 2010.
- A 15 percent one-time reduction to free field systems rates effective July 1, 2010.
- A 25 percent one-time reduction to free field “farm land” systems effective July 1, 2010.

In addition, if demand surpasses 3.5 GW annually, the FIT will be reduced by a further 2.5 percent. The next step down will occur if demand surpasses 4.5 GW, at which point the FIT will fall by another 2.5 percent. On the other hand, if demand is below 2.5 GW, the FIT will increase by 2.5 percent. These adjustments, though, will be finalized at the end of March.

Germany’s response seems to be as much a reaction to its own expense control as to the progress of the solar industry. Solar is becoming a larger part of the government’s bill since it is growing so fast, and in recessionary times it is not surprising that the government would look to cut back on its subsidization. Not purely a financial reaction, it is also a sign that the industry is progressing and is able to operate without training wheels. The solar industry has indeed lowered costs dramatically over the past year as polysilicon prices fell and technology improved.

All else equal, the effect of the cuts would be felt primarily by project developers, who would be compensated at a lower rate for the electricity they sell to utilities. Developers are currently making above-average returns on solar plants (since module prices are low), so it has been theorized that they could absorb the effect of the FIT cut without bringing about a drop in demand. A more realistic scenario, though, is that demand will drop as the adjustments are enacted in Q2, prompting sharp pricing declines beginning in the second half of 2010. We think this will be exacerbated by the fact that most solar companies claimed high visibility into the first half and have built up inventories in anticipation. The April timeframe of the subsidy cut is also three months earlier than many companies had expected, potentially sweeping the legs out from under their Q2 estimates. Battle Road Research is now predicting anywhere from a 15 to 30 percent drop in selling prices over the 2010 year, necessary to incentivize project developers and spur demand.

As Average Selling Prices (ASPs) fall, solar companies will feel pressure to reduce their manufacturing costs to maintain profitability. We will likely see increased investments in research and development to revitalize what seems to be stalled efficiency levels. Yingli Green Energy (YGE), for example, is now investing in the research of a high-efficiency solar cell in a project dubbed PANDA. Companies will also continue to absorb any leftover high-cost polysilicon and look to reduce grams used per watt in production in order to prop up gross margin levels.

It is also notable that France recently announced that it would cut its FIT by 24 percent and Italy may be the next country to decrease its support of the industry. The cuts call into question the likelihood of recently-announced solar IPOs coming to fruition over the next year. Though the industry was poised for a strong first half of 2010 predicated on robust German solar installation ahead of the feed-in tariff reduction, looming subsidy cuts in three of the largest geographies may cause Daqo New Energy, Solyndra, and JinkoSolar to alter their equity plans.

The new subsidy environment will also put pressure on smaller and weaker solar players, especially those bogged down by debt, since cleaning up their balance sheets would require solid cash generation stemming from improving demand and profitability. Subsidy cuts will make this task much more difficult.

While the reduction of solar subsidies will cause substantial near-term pressure on the solar industry, calling into question some of the bullishness predicated on an unusually-strong first half of 2010, we think it is also a sign of a maturing industry that is becoming more self-sufficient and it will serve to separate the weaker from the stronger players. As a temporary demand reset, we see the reduction as a speed bump in the long-term scheme of the solar industry.

Most solar panel manufacturers rely on polysilicon as their primary raw material to capture electricity from the sun.

However, the price of the commodity has fluctuated sharply over the past two years as polysilicon producers ramped up production capacity to match rising demand for solar modules. Under-capacity and short supply in 2007 led the price to rise to $400 per kilogram, equivalent to about $2.80 per watt. This spurred manufacturers to lock in long-term contracts and invest in their own polysilicon production. LDK Solar (NYSE: LDK), Yingli Green Energy (NYSE: YGE), and ReneSola (NYSE: SOL) all had plans to begin polysilicon production for themselves, but some may now regret their expensive ambitions as polysilicon spot prices plummet, hitting $60 in the third quarter of 2009.

LDK Solar, a solar wafer producer, broke ground on its polysilicon production plant in August of 2007, at a point when polysilicon was around $350 per kilogram (kg) on the spot market. It would build a small plant and three larger plants, with an original plan to produce 150-350 metric tons (MT) of the material in 2009 at its smaller facility and a further 5,000-7,000 MT at its larger facilities in 2010.

LDK has now delayed its polysilicon production facilities several times due to issues in plant commissioning and poor market demand for wafers. The company lowered its 2009 target to 15-25 MT for the year. The company’s larger project—a 15,000-MT capacity plant—was originally slotted to reach full capacity in 2009, but 10,000 MT of capacity have been pushed back until further notice. Production targets for the year have also been cut by 66 percent from the original estimate of 5,000- 7,000 MT over 2009.

It will be several months—assuming no more construction or processing delays—before LDK starts making significant quantities of silicon. We continue to have concerns about the quality of the polysilicon produced since as a new entrant, the company will not likely achieve anywhere near the efficiency or quality of the more experienced silicon players. Also, the company expects its initial batches of polysilicon to cost the company around $80 per kg, with the cost falling as low as $35 per kg over a few years’ time as the company benefits from economies of scale.

Intriguingly, just this past week, LDK sold a 15 percent stake in its polysilicon plant to a Chinese trust and investment company for $219 million. Although this will relieve some liquidity concerns surrounding the company’s high level of debt, it may also be an acknowledgement that the project was ill-timed and proved to be more costly than anticipated.

On January 8, 2009, Yingli Green Energy completed the purchase of Cyber Power for $77 million, a development stage company with plans to begin production of polysilicon in the second half of 2009. This acquisition will make the company fully vertically integrated since it will produce everything from raw polysilicon to complete solar panels. Yingli expects that it will be able to produce silicon for $60 per kg during top production periods (likely six months out), and then after stabilizing it, expects to reach costs of $30-$40 per kg, followed by costs as low as $25-$30 per kg after a year.

ReneSola, a solar wafer producer dabbling in polysilicon and modules, completed the first phase of its 3,000 MT polysilicon plant and expects to produce 200-250 MT before the end of 2009. The company declared that its current production cost is below $55 per kg, and it expects costs to decline to $50 per kg by the end of 2009 and below $40 per kg by the end of 2010.

While investments in polysilicon plants looked extremely profitable in 2007 and 2008 when the raw material cost over $300 per kg, the projects have proven to be much riskier than anticipated. The spot price of polysilicon has fallen to below $60 per kg, making it much more difficult to produce at a profit without economies of scale. All three companies will be producing batches at costs higher than market prices, so it will take time to ramp capacity to bring costs down. The market spot price is also expected to stay low, at least until solar demand shows more signs of stabilization. It is also evident that commissioning and ramping a poly plant is not easy. LDK suffered numerous setbacks in its plant construction, causing it to push back production targets and delay mass production until further notice. These companies have invested significant capital in these projects, so it may be difficult to back out of completing them.

Until these solar players produce meaningful quantities of the raw material at low cost and sufficient quality, we are taking an “I’ll-believe-it-when-I-see-it” approach.

The solar industry has long grappled with the timing of arguably its most important milestone, grid parity, which will be achieved when the industry is able to become price competitive with conventional grid-supplied electricity. With the cost of raw materials, namely polysilicon, falling rapidly and certain manufacturers ramping up to achieve economies of scale, the light at the end of the tunnel may be closer than anticipated. The industry is closer to grid parity in certain geographic locations, particularly those that already have high costs of generating electricity like Italy. As electricity becomes more expensive and the industry continues to achieve economies of scale, which is an important factor in lowering the cost of producing solar energy, it will be possible to close the gap in many more geographies. Until then, the industry will continue to be dependent on subsidies to enable competitiveness.

At present, feed-in tariffs, tax credits, and other government subsidies offset the high cost of solar electricity in order to make it competitive with electricity generated by burning fossil fuel. The expensiveness of solar power is driven by high up-front capital expenditure, expensive raw materials, and a lack of scale. However, companies like First Solar (NASDAQ: FSLR, $156.25) are quickly ramping up capacity to achieve economies of scale. Elsewhere, the price of polysilicon has plummeted, and capital expenditures are looking more affordable as projects’ ROIs improve. These factors may contribute to the industry’s achievement of grid parity earlier than anticipated.

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As solar manufacturers struggle to regain their footing after demand evaporated in the wake of the financial crisis, companies like First Solar are looking to under-penetrated geographies holding the promise of government subsidies to reignite sales. Solar demand was dominated by Germany and Spain in 2008, with the two countries contributing more than two thirds of global demand due to generous government feed-in tariffs. In 2009, though, pressure on Spain’s budget forced the country to cap its total subsidized capacity at a level that was about one sixth of its 2008 demand. Germany, and the rest of the world, are now forced to pick up the slack.

Two countries that were barely on the map in terms of solar installations in 2008, the US and China, however, are now the fastest growing and most promising future geographies for solar activity. The US solar market was about 350 MW, or only about six percent of the 5.5 GW market in 2008. China’s share was even less. New renewable energy goals and government subsidies, though, are expected to ignite growth in both countries. The US currently has in place an Investment Tax Credit, which pays for 30 percent of a solar installation in cash or tax credits, and China is in the process of enacting its Golden Sun Program, which will support the installation of 500 MW of solar farms over the next two to three years. The Chinese government will subsidize as much as 50 to 70 percent of the costs of a solar project through the program, and there are plans to initiate a feed-in tariff as well.

The Chinese solar market is still in its infancy, but there is an increasing level of deal activity in the region. While we previously expected the Chinese market to be confined to mainly China-based solar companies, First Solar has signed a Memorandum of Understanding with the Chinese government to build a two gigawatt solar plant in Mongolia. To put this into perspective, one gigawatt is enough energy to power roughly 800,000 homes depending on the location. Though this is not a near-term catalyst for FSLR’s demand, we see this as a move to establish a solid footprint in a growing solar market. Other companies have also signed preliminary plans for large installations in China: Suntech signed letters of intent for 1.8 GW of projects in the country, and ReneSola has a pipeline of about 505 MW.

Several companies have begun efforts to open up the US market as well. First Solar signed a contract with the Los Angeles Department of Water and Power (LADWP) to build a 55 MW project in California in August. First Solar also expanded its relationship with Southern California Edison, agreeing to build two installations in Southern California with a total capacity of 550 MW. These projects add on to the company’s already impressive pipeline of 650 MW worth of utility deals with Sempra Generation, Pacific Gas and Electric, and others, as well as 1.3 GW worth of utility deals in negotiation. With these projects First Solar is building important US relationships, which we think will prove to be valuable as companies compete for solar subsidies. The deals should position the company for a larger share in the market as it evolves. SunPower is also positioning itself to win US business, with a 600-800 MW deal with Florida Power and Light and a 200 MW deal with PG&E.

As the solar market evolves and matures, companies will begin to target high-growth, under-penetrated geographies like the US and China, especially as government incentives solidify. Though many of the large deals being signed by companies like First Solar will not necessarily spark near-term demand, we think it will allow them to develop a footprint in these emerging markets and gain share as the markets grow.

While reviewing First Solar’s first quarter earnings, we were surprised by the dramatic rise in receivables on a decline in revenue. The company generated revenue of $418 million, down four percent sequentially, while its accounts receivable balance rose 300 percent, from $60 million to about $180 million. This had a substantial negative effect on the company’s cash flows. Since cash received from customers was down $100 million (25 percent) on a sequential basis, FSLR had net negative cash flows for the quarter. In addition, the company’s tax rate fell from 23 percent in the fourth quarter of 2008 to three percent in Q1 on a one-time Malaysian tax refund. This gave the company a $0.15 boost to its bottom line.

First Solar chose to extend the payment terms for its customers from 10 days to 45 days in the most recent quarter, giving the customers more flexibility in light of heightened uncertainty and credit difficulty in the solar industry. As a result, the company’s DSOs nearly tripled in the first quarter of 2009. We see this as evidence that FSLR’s customers are having increasing difficulty obtaining funds and maintaining liquidity, as well as potentially having working capital issues. This dramatic rise in receivables also raises the specter of write-downs and bad debt expense in the future. We also think that the company will burn cash at a faster rate going forward since it is receiving substantially less cash from customers. The company continues to invest in expanding its Malaysian plant capacity and financing large German solar projects, which will require continuous funding.

Though First Solar beat estimates for the first quarter of 2009, we think that it has hit a brick wall based on its receivables soaring 300 percent on a decline in revenues and its bottom line being artificially boosted by a one-time Malaysian tax refund. Because of these issues, we have concerns about the quality of First Solar’s Q1 earnings.

The Chinese Ministry of Finance proposed its “Solar Roofs Program” on March 23, 2009, in order to jumpstart the domestic Chinese solar market that has until now been virtually non-existent. By our estimates, demand in China was about 70 MW in 2008, or less than two percent of the 4.5 GW of worldwide demand. The project would offer financial incentives up to CNY 20/watt (depending on technology and degree of integration with the building) of installed PV capacity for projects that meet the following standards:

• Installed capacity for projects must be at least 50 kWp.

• The systems must meet efficiency standards of 16 percent for monocrystalline products, 14 percent for multicrystalline, and six percent for amorphous silicon.

• Priority will be given to “building-integrated PV applications,” grid-connected applications, and projects involving schools, hospitals, and government agencies.

The proposed subsidy is significant, for it will represent over 50 percent of the total cost of installation of a panel. CNY 20/watt is about the average cost of a solar panel (just under $3.00 per watt), so a project developer would only have to pay for installation, which generally costs slightly less than the panel itself. This subsidy would differ from the feed-in tariff structure, made popular by Germany and Spain. While feed-in tariffs require utilities to purchase electricity from solar power plants at a higher-than-market rate, the Chinese subsidy will be a capital-cost subsidy, in which the government provides a fixed amount of money per watt or kilowatt installed.

The terms of the subsidy tell us a few things about what the Chinese government is aiming to achieve. A 50 kw system is a fairly large system for a rooftop application, since a mid-level solar panel is generally in the 150-200 watt range and a project of that size would require over 300 panels. This seems to indicate that the subsidy will promote larger-scale rooftop projects, which rules out residential applications and likely targets the commercial market. The government also seems to be promoting technological advancement by setting minimum efficiency standards. Yingli Green Energy (NYSE: YGE), for example, only sells a handful of models of its multicrystalline panels with over 14 percent efficiency. Finally, there has been some discussion as to the exact meaning of “building-integrated” applications. BIPV in the US generally refers to solar panels that are built directly into new construction, rather than simply mounted on rooftops. We think that the reference in the subsidy proposal most likely does not refer to BIPV applications in the US sense, since the market for building integration in China is very small and crystalline products are not generally used. However, if it does in fact refer to such applications, they may simply receive priority over rooftop-mounted projects, rather than the latter being disqualified from the subsidy entirely.

Still unclear, however, are the limitations of the subsidy. Firstly, the government has not set a time schedule for designing the program, so it is still unknown when the program will be finalized and when incremental demand will be seen. Secondly, the funding budget for the program has not yet been determined, and no cap has been decided upon, so the number of MW to be supported is still unknown. We think it is unlikely that the program will have no cap, especially after Spain’s rush of installation in 2008 before the country capped its 2009 capacity. There have been rumors of a cap of 180 MW (representing a budget of CNY 2.5 billion), which would significantly limit the scope of the program.

Overall, the subsidy is a generous one, and when it is finalized it will surely be a positive development for China-based solar module producers like Suntech (NYSE: STP), Yingli, JA Solar (NASDAQ: JASO), and Trina Solar (NYSE: TSL). At the least, it is an indication of the Chinese government’s support of the solar industry. However, we think there is likely to be a cap, and we estimate demand in China growing an incremental 200 MW in 2009 as a result, which is not very substantial in a worldwide demand pool of about four gigawatts.