Monday, November 22, 2010

Solar Stocks = Value + Growth

Normally investors in a fast growing sector like solar need to be careful of valuations becoming stretched. P/Es in fast growing sectors will sometimes reach 2-3 times the market average.

Oddly for a market where q1 2010 opened with fears of oversupply and a resulting price war, demand exceeded expectations (100% year over year growth), prices remained stable and a "goldilocks" market ensued in which valuations for most solar stocks have contracted significantly. With only a few weeks left to the year, many solar stocks are selling at 6,8 or 10 times FY 2010 earnings and 3, 5, or 7 times FY 2011 estimates.

One of two interpretations follow: 1) investors are correctly discounting an oversupply situation in 2011 (which the companies themselves do not see) and prices will decline significantly faster than costs leading to much lower earnings in 2011 or 2) this is a unique opportunity to buy into one of the fastest growing industries of the decade, at prices that deeply discount the value and growth potential of the sector.

While the future is inherently uncertain--an oversupply could occur, and investors need to watch this aspect closely--it seems that Wall Street is overly pessimistic about solars, by projecting absurdly low future stock valuations. Just on Friday an analyst at Wedbush downgraded SunPower (SPWRA then trading around $13/sh) and reduced their target price for SPWR from $11/sh to $7/sh. This came only a day after the company confirmed FY 2010 earnings guidance of $1.50/sh and provided FY 2011 earnings guidance of ~$1.90/sh.

SPWRA is now trading around $12/sh, which means the company's FY2010 P/E is 8 with less than 6 weeks to go in the year. And its FY 2011 P/E is just above 6, despite the anticipated 30% growth from 2010-2011. The company is also selling at a discount to book value (P/B = 0.84). Yet the Wedbush analyst thinks the stock is 70% overvalued...(at $7/share the 2010 P/E would be 4.8 and the 2011 P/E would be 3.6 and the P/B would be under 0.5). Such pessimism strikes me as extreme given the current rapidly growing solar market.

Another stock that I follow is LDK Solar which is a Chinese solar play. The company is projected to earn $2 in 2010 and maybe $4 +/- $1 in 2011. LDK trades just a little above $11/share, meaning its FY 2010 P/E is already near 5.5 and its FY 2011 is around 3. I could imagine this valuation on a company that is in serious trouble or embarking on a major restructuring, but not on fast growing profitable companies. Something is out of kilter, and I say its the low valuation!

With the exception of thin film leader FSLR, which is trading at a market multiple, nearly every solar I know of is trading at a substantial discount to the market P/E, yet their revenues and earnings are projected to grow at least 30% in 2011.

The above earnings estimates are predicated on solar panel prices dropping ~10% in 2011. This means that price drops significantly greater than 10% could negatively impact these stocks earnings (although P/Es at 1/3 to 1/2 the market multiple somewhat reduce the downside to stock prices). Since Germany currently installs about 1/2 of all solar panels in the world, the German market support (Feed-in-tariff) is especially important to solar companies. They are set to reduce their FIT 13% in 2011--which is well known in the industry.

While a 13% reduction may sound large, the country reduced its FIT by 26% in two stages in 2010 which partially explains why the Germans will install 2x as much solar in 2010 as in 2009, as companies rush to install panels ahead of these FIT reductions. Assuming Germany leaves its FIT alone in 2011, I don't see any cause for panel prices to drop more than ~10% in 2011 (b/c the economics would be similar in both years for the installers). If Germany were to announce an additional one time large cut to its FIT, this could depress panel prices (although first there would be a surge to install panels ahead of the extra cut). The larger the expected cut the larger the rush. Another possibility that could depress prices is if Germany were to cap the amount of solar at some value below ~10GW/year. Current estimates are for 7-8GW to be installed in 2010 so a cap of say 8GW would imply ~zero growth for the largest solar market and that could put downward price pressure on other markets.

What can sometimes get lost in all this talk of earnings, estimates, and FIT rates is that the solar industry is growing quickly because it supplies safe, reliable and clean power (at a lower and lower cost each year) to a planet desperately in need of exactly this.

Solar companies can bring down prices each year because they benefit from "economies of scale" (it is cheaper to make, or install--per unit--1 million panels each year than it is for half as many) and what is sometimes called "economies of learning" (the concept that you get better at doing something the more times you do it).

There will be stumbles and misses whenever an industry is growing as fast as solar currently is: 50% compound annual growth rates. The only thing investors can do is make sure they buy into companies at valuations that balance the risks and rewards available. It seems to me that now is a rare opportunity (b/c of a flawed Wall Street consensus) to buy into a rapidly growing industry at an exceedingly low valuation.


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