Jan 8, 2013

Solar Sector Update: Massive Debt + Muted Rebound = $0


by Morning Star Analyst, Stephen Simko, CFA

Since the solar downturn began in early 2011, barriers to industry consolidation have been ever-present in the form of local Chinese officials being more concerned with employment than rational lending practices. As leading Chinese solar companies employ tens of thousands of people, access to financing has continued unobstructed despite the fact that every solar manufacturer in China is now hemorrhaging serious money. Companies that should be going bust are still open for business because they're able to burn cash by drawing down short-term debt. This in turn has led to huge increases in leverage. It's not an exaggeration to say that Chinese lending practices are single-handedly preventing the rationalization that the solar industry so desperately needs.

A year and a half into the solar downturn, unchecked leverage has ballooned to the point where debt is now squeezing most if not all of the value out of equity at the majority of solar companies. As we look across our solar coverage, there are four companies where we believe this has occurred. Three aren't particularly surprising: the financial problems of LDK Solar LDK, Renewable Energy Corp. REC, and Suntech STP are well-documented, and it will be hardly be a surprise if any of these companies wipes out their equity base in order to restructure their balance sheets. But we also believe cost leader Yingli Green Energy YGE also has also reached the point where its bloated debt burden has effectively smothered out the value of its equity. For each of these companies, our new fair value estimates are $0. 

Yingli is almost never mentioned as a firm with irreparable debt problems. But because its net debt has increased by $1.5 billion in the last two-plus years, we think this description is fitting. In our view, there is ample evidence that the equity of one of the lowest-cost structures in solar and the company with the highest market cap in China no longer holds any shareholder value. Beyond its huge debt load, the reality is the solar industry faces structural headwinds--massive cuts in subsidies, cutthroat pricing in new growth markets, changes to business models--which are likely to prevent margins from rebounding to anywhere near predownturn levels. In such a scenario, Yingli won't come close to generating sufficient cash flows from its business to justify its current enterprise value. We think a debt restructuring is all but unavoidable.

In our view, Trina Solar TSL is the right way to play a potential upturn, provided that a bottom is reached relatively soon. Operationally, Trina is almost the exact same company as Yingli. The companies' production footprints and cost structures are very similar, and their 2010-2011 EBITDA (excluding charges) were roughly the same. What differentiates them are their capital structures: Trina has $1.4 billion less net debt and interest expense is running at half that of Yingli. To be sure, if the Chinese government continues to prop up zombie solar companies for too much longer--and it's impossible to know exactly when access to capital will be sufficiently cut off--Trina could see its own equity value crowded out by debt. But if consolidation happens sooner than later, we think this is clearly the stock to bet on.

For First Solar FSLR, margins won't be great, but enough to warrant a fair value estimate increase. First Solar has fallen behind the lowest-cost Chinese producers, but the company's technology looks likely to be able to reduce costs faster than its peers during 2013-2016, especially when one considers polysilicon prices (15%-20% of Tier One China's costs) are likely to increase in the medium term. By 2015 we expect First Solar's module costs will have fallen to $0.56, inclusive of an $0.08 efficiency penalty, at which point we expect Tier 1 China to be at $0.59, assuming $25 per kilogram silicon pricing. This is by no means a ringing endorsement of First Solar, but it does suggest that it still has a fighting chance to be one of the industry's long-term winners. We are raising our fair value estimate to $37 to reflect our expectations that the company will be able to generate profits (albeit at very slim margins) once its pipeline of high-margin legacy projects runs out in 2015.

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