Dark Days for the Solar Industry

After years of breakneck growth, dynamics within the solar industry have rapidly changed. Recently, the demand for solar power has been hurt significantly by both tighter lending to project investors and the introduction of a 500-megawatt cap on Spain's solar subsidy program (the world's largest last year) that will shrink the Spanish market by at least 80% in 2009. Although the United States and China offer very attractive long-term stories, both markets remain relatively undeveloped, and it is likely newly announced incentives/subsidies will not materially increase installations until 2010. As a result, we expect growth in global solar installations to decrease for the first time this decade in 2009 (see Chart 1) because there simply is no market than can replace the 2-gigawatt (33% of the 2008 global total) reduction in demand from Spain.

The downturn in demand highlights another serious issue that was clearly emerging last year: The industry presently has far too much supply. During the solar boom of the last few years, demand consistently outstripped supply, and essentially every solar panel produced was sold. Solar companies could increase sales as quickly as they could expand production, all the while at very profitable levels. Not surprisingly, new entrants flooded in, and existing companies expanded rapidly, with the whole industry planning as if high double-digit growth were set to continue indefinitely.

Given the cap in Spain and the lack of financing for new solar projects, such growth is far from the case. For the first time in years, supply exceeds demand in the solar industry. There is evidence of this along the entire solar supply chain--from raw materials (such as silicon and related materials) to solar panels--and selling prices have collapsed during the last nine months at all points.  MEMC Electronic Materials , a major producer of silicon, is a prime example of a company enduring the havoc that falling average selling prices (ASPs) are wreaking on the solar supply chain: First-quarter sales declined by 50% sequentially, and as a result, operating margins fell from 39% to negative 12%. The travails of silicon producers are not translating into high profits for solar companies further downstream. The ASPs of cell and module makers have fallen anywhere from 20% to 60% during the last nine months because lower raw-material costs are being passed through to try to reignite stagnant end-project demand.

In our opinion, oversupply will last at least a few quarters before a return to any sort of normalcy in the solar industry. Despite many marginal and smaller companies exiting the industry, supply clearly still exceeds demand. Inventory levels have risen significantly within the industry, which we view as a red flag. This week, Q-Cells, Europe's biggest solar cell company, preannounced that sales will be down 40% sequentially in the second quarter and that inventory levels have risen further from already-inflated levels. We are skeptical industry inventories can return to healthy levels without further double-digit reductions in selling prices. Consequently, we expect industry profitability to remain far below previous levels even as shipments begin to revive this summer.

Given these poor dynamics, we expect a further industry shakeout to ensue, as inefficient, high-cost companies lose market share to the industry's low-cost manufacturers. The next few quarters will likely be challenging for all companies, but we believe  First Solar  (FSLR),  SunPower (SPWRA),  Suntech , and  Yingli Green Energy  are well-positioned to weather the storms and survive the current downturn.

First Solar Continues to Outperform the Competition
Our favorite name in the industry, First Solar, is a company we recommend keeping an eye on as a potentially attractive investment. During the last few years, First Solar has grown from obscurity into the world's largest solar company on account of its unique production process that allows it to manufacture solar panels at costs below its competitors'. Unlike the majority of the industry which produces silicon-based solar panels, First Solar uses cadmium telluride to convert sunlight into electricity. This allows it to employ a simplified production process that is much more fluid and much less labor-intensive than manufacturing silicon-based products.

As the industry's low-cost producer and a firm which also continues to consistently reduce its costs (see Chart 2), First Solar is the one solar cell/module company that hasn't seen profitability collapse because of the downturn. In fact, the company's profitability has actually increased during the last nine months. We believe this outperformance will continue, and we feel at the right price, First Solar remains the industry's most promising investment.