SunPower And First Solar Appear Oversold, Integrators Are Unattractive Investments

Dec 8 2008 | 12:00am ET

By David Kurzman -- The recent passage of the federal bailout bill, which includes an extension of the Solar Investment Tax Credit (ITC), has created an estimated $400 billion, eight-year solar market opportunity. Solar stocks have been beaten down and this could lead to a bounce in selected names, but we are very cautious long-term due to competitive pressures and the likelihood of consolidation. Also, these incentives will cause share prices for solar-related companies to experience excess volatility.

Based solely on the eight-year extension of the Solar ITC, we estimate that a $400 billion market literally developed overnight. Though previously available only for commercial installations, the ITC has been extended to residential installations, effectively removing the $2,000 cap. We expect between 30 Gigawatts and 35 Gigawatts of new capacity will be added over the eight-year period beginning Jan. 1. This compares favorably to the less-than-1 Gigawatt that was installed in 2007.

Also, the average installed cost per-Watt for photovoltaic installations should decline to around $4 from the current $6 to $9 level. Beaten down solar stocks, such as First Solar and SunPower, are likely to see a bounce from current levels of about 15x 2009E EPS and 8x 2009E EPS, respectively, as they will continue to generate exceptional growth rates (>30 annually).

Over the longer-term, we are concerned for smaller, higher-cost photovoltaic manufacturers and integrators as competitive pressures within this highly fragmented industry and falling home prices will create a tremendous headwind. The solar integrators, in particular, appear poorly positioned as they possess few competitive differences, compete mostly on price and advertising dollars/word-of-mouth, and have narrow operating margins.

Consolidation will be a driver for the solar industry for many years, waxing and waning with rising and falling market valuations. Current market valuations lend themselves to consolidation, and we would rather own the best-in-class companies at a reasonable valuation over the long term than depend upon a rising tide to make our money. In fact, we believe that strategic investments and M&A activity will be the primary banking activity in the CleanTech sector for at least the next six months.

Solar Integrators Make For Poor Public Investments
We view solar integrators as similar to electricians: why would you want to own a publicly traded company of electricians? They tend to be blue-collar, local-market service providers with little to differentiate themselves competitively. Furthermore, the parts they require for each installation are in increasingly short supply, which can extend project install periods. For a business that depends upon volume to make its money, fast and efficient installations are key, and installation delays can be the kiss of death.

The average residential PV installation is a 4.5kWdc project, has a price tag of $36,500, requires about a week to install and test, and the solar “integrator” (installer) generates about a 10-15% profit margin in good markets. The working capital needs are significant, thus reabsorbing the cash flow generated. The opportunity for operational missteps are significant, though this should decline as training programs are developed and experience with installations increase.

Furthermore, as home prices decline and foreclosures and delinquencies rise, installing a PV array is unlikely to be on the top of many homeowners’ minds. In fact, if their market capitalizations were higher, we would be inclined to recommend shorting selected solar integrators.

Expect Photovoltaic Manufacturers To Consolidate
Our best ideas are SunPower and First Solar, which are reasonably priced for their prospective growth, have sufficient capital, generate free-cash flow, and have secured numerous long-term sales contracts. Most importantly, First Solar is the low-cost industry producer and SunPower manufactures modules with the highest efficiencies. These factors make them stand apart from their peers.

Over the long term, we view the PV cell and module manufacturers similarly to the automotive industry, but without some of the advantages. Though we can not guess as to when it will occur with precision, we are confident that solar cells and modules will commoditize and profit margins will collapse. There are hundreds of cell, module, assembly, and related photovoltaic companies worldwide, and we expect this industry to drastically consolidate over the next decade as the survivors seek to remove competitive threats and acquire technological advantages.

If this sounds like a familiar refrain, perhaps it is because history is littered with similar scenarios. For instance, following the invention of the automobile and the airplane, there were hundreds of manufacturers, suppliers, assemblers, and servicing companies launched to support the growth of these industries. The markets eventually consolidated, margins collapsed, and differentiation developed (when it was possible).

There is a lesson to learn here: Unlike the Photovoltaic industry, the automotive and airline industries did not benefit from a 30% incentive tax credit to spur their growth. Instead, they were dependent solely upon their underlying business models for growth and earnings. The solar ITC creates an opportunity for an otherwise non-economic technology to enter the commercial market. Accordingly, I fear that the valuations for photovoltaic companies can, and will, experience much wider swings than the automotive and airline industries ever faced.

First Solar just invested $25 million in a private solar integrator, Solar City. As part of their investment, First Solar will sell 100 Megawatts of modules to Solar City over the next five years. But don’t fret for First Solar, as they made off like bandits: I estimate they will make at least a 25% IRR from the sale of modules to Solar City, even if their investment returns zero.

Within 30 years, I would not be surprised if the number of worldwide manufacturers and suppliers in photovoltaic module and cell manufacturing were to consolidated to under 20, and that margins were to collapse (probably more than once) and commoditization were to occur. It remains to be seen how factors such as design, operational performance, and manufacturing productivity (which have become differentiators among automakers like Chrysler, Toyota, AirBus, and Boeing) will develop.

As a trade, owning First Solar, which is the low-cost manufacturer of solar modules at about $1.15 to $1.35 a Watt, makes sense at the current market valuation of $11 billion and 22x next year’s estimates, but we will be quick to remove it from our list as the market price rises. SunPower is also a reasonable valuation at 13x 2009E EPS, and its strategy to become vertically integrated and maintain a leadership in cell efficiency will differentiate the company’s products for the time being.

David Kurzman is Managing Partner of Kurzman CleanTech Research and Kurzman Capital. Prior to launching his consulting firm, he served as Managing Partner of Kurzman CleanTech, a five-year-old hedge fund investing in clean technology companies and led the CleanTech Research Group for Panel Intelligence, a primary research firm.

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