A Guide for the Solar Investor

CSLA picks 15 solar companies for a balanced portfolio of stocks

Monday, August 15, 2005

Solar remains an attractive investment both for those who already own stocks in the sector and those looking at solar power for the first time. In his monthly article, Michael Rogol, a stock analyst at Credit Lyonnais Securities Asia (CLSA) and author of the Sun Screen II PV market study, examines solar from an investor's point of view.

The solar power sector is having a very good year. Based on a global review of more than 600 companies involved in solar for our Sun Screen 11 report , we estimate that production, revenue, and profit will continue to expand quickly, and that this will drive significant stock price appreciation. We expect the PPVX, which increased 167 percent over the last year to 1,808 points on July 1, will continue to move upward. Despite the steep appreciation of many solar stocks, this sector remains cheap, trading at under 20 times expected 2006 earnings.

Risk and reward

We remain firmly convinced that solar stocks offer significant upside - often two- to threefold over two to three years. But this could be offset by several risks, with silicon supply constraints being the most important. Yet, ironically, the tight silicon market creates a significant advantage for many players. The solar sector is dominated by a dynamic where companies with feedstock supplies are elated and those without feedstock supplies are desperate. Downward pricing pressure for wafers, cells, and modules has disappeared, and companies with silicon are quite happy while those without silicon are deeply frustrated. The downside is being acutely felt by smaller solar players who have been unsuccessful in securing feedstock supplies, resulting in lower utilization rates, lower profit margins, and unfulfilled growth plans.

Fifteen priority stocks

The core challenge for investors is to identify fast-growth solar stocks that have limited risk of falling short in securing silicon supply. Frankly, we believe that the condition of the silicon market creates risk for nearly all solar companies, even those with apparently strong relationships with suppliers. As a result, we strongly advise investors to pursue a portfolio approach rather than picking individual stocks.

As we screened solar power companies, we sought to identify the industry leaders that are likely to not only ride the industry wave, but to outpace it. In addition, because we are highly sensitive to the industry's risks (especially the short silicon supply), we sought ways to minimize exposure while still investing in rapid growth.

We have identified 15 of the brightest stocks in the sector and suggest that investors carefully consider a portfolio of the following stocks (listed alphabetically):

ATS (ATA Canada)

Parent company of the largest solar company in France (Photowatt). Its solar business accounts for 35 percent of operating profit and is a key driver of the company's earnings-per-share growth. We see significant upside in stock price in 2006 if enough silicon can be secured to match expansion plans.

Carmanah (CMH Canada)

Largest Canadian solar power company and manufacturer of the world's best integrated solar products (e.g. streetlights, bus shelters). With more than 50-percent gross margins, expanding net margins, positive cash flows, and distinctive solar products, we expect Carmanah to either see very strong stock price appreciation or become an acquisition target for global lighting players.

Conergy (CGY GR)

World's largest solar wholesaler and a leader in German installations. We see realistic potential for at least 60-percent earnings-per-share growth in 2006 and 32 percent in 2007, and for significant stock price appreciation (more than 100 percent) over the next two years.

Evergreen Solar (ESLR US)

Owner of distinctive string-ribbon wafer manufacturing process that has realistic potential to be the "next generation", for c-Si wafers and grow profitably from 14 MW of production in 2005 to 1 GW in 2010. We see realistic potential for the company to generate net profit for the first time by mid-2006 and for the stock (trading on the Nasdaq at $6.63 per share on July 22) to trade above $8 (20 times 2007 earnings) in the next year and above $28 (20 times 2008 earnings) in the next two years.

Kyocera (6971 JP)

World's second-largest solar company, with 105 MW of cell production in 2004. Kyocera is quickly following Sharp's rapid scaling and will have approximately $560 million in solar revenue and $110 million in solar pre-tax profit this year. Already, solar is 10 percent of Kyocera's total operating profit - ¥12 billion ($108.2 million) out of ¥120 billion ($1.08 billion) total - and has much higher operating margins than its overall business (approximately 20 percent for solar compared with 10 percent for the company overall). We see solar growing to at least 16 percent of total operating profit within the next two years, with potential upside.

MEMC (WFR US)

One of the world's larger silicon manufacturers, we estimate the rapid rise in silicon prices and corresponding increase in wafer prices will push up silicon-related earnings in 2006. If our expectation for silicon prices plays out over the next year, MEMC will see approximately $25 to $35 million in incremental revenue with little (if any) additional cost. This alone would provide 11- to 15-percent earnings growth for the company compared to 2004. Given the tight silicon market, we expect silicon prices to continue rising for at least 12 to 18 months, with potential for silicon prices to go even higher than our estimates. All of this is good news for MEMC's earnings growth.

Motech (6244.TW0)

Leading Taiwanese cell and module player that is aggressively searching for ways to overcome tight silicon supplies in order to meet very aggressive growth targets. We see potential for significant stock price upside over the next two to three years if it succeeds in securing enough silicon to match its growth plans. In addition, stronger policy support from the Taiwanese government could create a trigger for significant stock price appreciation. We include Motech in our solar portfolio to create exposure to this upside.

Q-Cells (IPO GR)

Germany's largest cell producer with distinct ability to set up new facilities and form partnerships with emerging industry leaders. We expect an IPO in the coming months and see initial market cap of $1.4 to $2.8 billion (assuming 20 times 2006 or 2007 earnings), with realistic potential to grow to $4.2 billion by 2010 (assuming 20 times 2010 earnings). One key question for Q-Cells is how it will manage its partnership with Evergreen in EverQ but we see enough upside from the joint venture to make investments in both companies quite attractive.

REC (1120 Norway)

Among the top silicon producers and wafer makers in the world, REC has very strong margin growth potential due to cost reductions and upstream integration. We expect an IPO in the coming months with an initial market cap of $1 to $2 billion based on a rough estimate of a twentyfold increase in 2006 and 2007 earnings. In addition, REC has proven its willingness to execute deals with the acquisition of SGS and ASiMI, so we see further upside through potential future acquisitions.

Sekisui Chemical (4204 JP)

World leader in highly automated construction of prefab homes. With 60 percent of homes manufactured with solar, Sekisui Chem is among the world's top solar installers and has option-value by potentially pursuing other opportunities in domestic and overseas solar markets either directly or in partnership. Based on discounted cash flow, we see 30-percent upside over next 12 months.

Sharp (6753 JP)
World's largest solar power company with $1.5 billion in solar revenue and $150 million in solar pre-tax profit this year. Sharp's solar revenue is expected to grow to approximately $5 billion by 2010. The company currently guides for approximately 10-percent operating margins from its solar power business, but we see realistic potential (not included in our modelling) for 20 percent. With solar becoming a leading driver of earnings growth, we see substantial upside.

Solartron (SOLAR Thailand)

Thailand's leading solar power company. While small (only $25 million in revenue in 2004), this company is well positioned to benefit from increasing Thai government support. With government officials suggesting Thailand will undertake a large-scale program for electrification using solar power, we see significant upside potential for Solartron's stock price. We include Solartron in our solar portfolio to create exposure to this upside.

SolarWorld (SWV GR)

SolarWorld is the largest solar stock by market cap ($1.1 billion) and is one of Germany's leading solar companies (revenue $360 million). We see the stock reaching €100 to €130 ($121 to $15 7) in the next 12 to 24 months, as net profit increases from €33 million ($39.9 million) in 2005 to €47 million ($56.9 million) in 2006 and €63 million ($76.3 million) in 2007. We see significant upside potential beyond these estimates if SolarWorld pursues stronger-than-expected downstream integration (i.e. making more cells from its wafers and more modules from its cells), achieves larger-than-expected cost reductions, or pursues faster-than-expected capacity increases.

SunPower (IPO US)

Currently a subsidiary of Cypress Semiconductor (CY US), this fast-growing unit has the world's best cell efficiencies, capturing premium prices while keeping costs down by manufacturing in the Philippines. We expect an IPO later this year with an initial market cap of $400 to $700 million and strong potential to expand to more than $2 billion by 2010. It is worth noting that SunPower's IPO has realistic potential to put upward pressure on multiples for solar power stocks across the globe by establishing the US's first large, pure-play, profitable solar company.

Tokuyama (4043 JP)

Japan's largest silicon producer, with silicon accounting for 46 percent of total operating profit in 2005. We see the stock outperforming this year, with potential upside in future years from profitable silicon expansion. We also see upside if Tokuyama's vapor liquid deposition (VLD) process for silicon manufacturing proves it can deliver substantial cost savings relative to traditional production methods.

Strong rationale for portfolio approach

We see these 15 stocks as an exciting portfolio for five reasons:

  • This is a portfolio of the companies best positioned to lead the industry. By 2010, Evergreen, Conergy, Kyocera, MEMC, QCells, REC, Sharp, SolarWorld, SunPower, and Tokuyama have realistic potential tohold a global market
    hare of 10 percent or more in their segments of the supply chain.
  • This portfolio has very strong earnings growth potential to outperform the indus try average through 2010.
  • We see a two- to threefold stock price increase potential for many of these stocks based on strong earnings growth and reasonable valuations. Several stocks - Conergy, Evergreen, Motech, Q-Cells, REC, SolarWorld, and SunPower - could realistically achieve this level by 2007-2008.
  • The portfolio minimizes risks through internal balances that reduce exposure. Due to the large number of companies, it is less likely to be exposed to significant downside from the tight silicon market. It is geographically diversified, thus less exposed to policy or currency changes in any one country. And it is diversified along the supply chain, which provides a balance to risks that one segment of the supply chain will falter due to overcapacity or inadequate feedstock. We view the reduction of risks from the portfolio as being much more attractive on a risk-reward basis than making an investment in any single solar stock.
  • This portfolio creates upside through one-off events that could have large positive impacts on solar stock prices. For example, if the Thai or Taiwanese governments passed a new pro-solar policy, Solartron or Motech would benefit. If the Los Angeles city government put out an RFP for a large number of solar bus shelters, Carmanah would benefit. If Tokuyama announced strong performance of its VLD silicon manufacturing process or if Sekisui Chemical entered into an appropriate agreement to jointly manufacture prefabricated solar homes in an international market, their stock prices would likely benefit. These types of one-off events are not guaranteed and are not the basis for investments in any specific stocks, but they do create significant upside potential for the portfolio as a whole.

Overall, we see demand surging, prices remaining solid, costs falling, production capacity expanding, and government support continuing for the next several years. In short, we expect that the sun will continue to shine for this solar port
folio.

Michael Rogol, Brent Fisher