In the long run, solar has a very encouraging future. Even petroleum powerhouse Shell foresees a world where solar is the largest energy source. But the market’s short-term dynamics are not as encouraging.
Solar has a stubborn and persistent oversupply problem. Many nations want to increase their share of global production and consumption, wreaking havoc on prices. Any potential solar investor should be aware of what they are getting into.
FSLR Return on Invested Capital data by YCharts
Based on analyst reports, the solar industry would need approximately 45 gigawatts of demand to use up its spare capacity. 2012 fell far short of that mark with only 29 gigawatts of demand.
Part of the industry’s challenge is the long lead time for a new manufacturing plant. Companies are not able to instantly adjust production to profitably meet demand, leading to significant periods of oversupply and undersupply.
What shipping can teach you about solar
The shipping industry has a similar dynamic. The long lead times for new ships and slow retirement of old ones causes violent cycles in profitable and industry capacity.
The secret in this industry is to invest when profits are low, and sell when rates are high. By finding shippers with enough cash to weather a crisis, and selling them when the shipyards are flooded with new orders, you can garner handsome profits.
Speculators love stocks with large amounts of ambiguities because they inspire investors to make rash and emotional decisions. In the solar sector, China’s Suntech Power Holdings Co., Ltd. (ADR) (NYSE:STP) provides a prime example. Recently it defaulted on more than $500 million in bonds. Its overall debt load was simply too great, with liabilities of more than $3.5 billion based on its last quarterly statement. Volatile prices made the company sell products at a loss to try and maintain market share.
Even with a three-year revenue growth rate of 17.62%, the firm had posted significant losses in 2010 and 2011. This stock shows that when you invest during a downturn, you need to find quality companies with manageable debt.
Rival First Solar, Inc. (NASDAQ:FSLR)‘s financials appear very positive. With a low total debt-to-equity ratio of 0.16 the company has almost no debt. Also, the firm’s gross margin of 33.1% and three-year revenue growth rate of 16.68% are encouraging. The low debt load decreases the risk of bankruptcy and the strong revenue growth shows that the company is growing along with the market.
Sadly, not all of the company’s fundamentals are as rosy. First Solar, Inc. (NASDAQ:FSLR) uses thin film technology, which offers a lower efficiency than other technologies. The firm’s cost per watt does not offer an advantage over Chinese firms. In the long run, it looks quite possible that competitors could catch up and eat away a large portion of First Solar, Inc. (NASDAQ:FSLR)‘s market share. The company needs to be examined with a degree of caution.
A higher-quality solar investment
SolarCity Corp (NASDAQ:SCTY) is a different animal. The company installs panels and leases them back to consumers, or offers electricity at a fixed kilowatt rate. This business model is fundamentally less volatile than the previously mentioned manufacturers. SolarCity’s financing costs and contract rates can be fixed to give the firm more stable margins.
This firm’s total debt-to-equity ratio of 2.15 appears high when compared to many manufacturers, but it should not cause alarm. The differences in the firm’s business models mean that SolarCity is better suited to take on debt.
With a price-to-book ratio of 8.77, the company’s trading at high industry valuations. Still, it doesn’t make the firm a poor investment. It recently IPO’d and is quite speculative, but it’s a great company to watch as it moves closer to profitability.
Conclusion
The solar industry is very volatile, and the recent default of Suntech Power Holdings Co., Ltd. (ADR) (NYSE:STP) is a warning against frivolous investing. Speculators love volatile stocks, and the firm’s high debt load makes it a great target. Volatile prices made it only a matter of time before Suntech Power Holdings Co., Ltd. (ADR) (NYSE:STP) would fall.
First Solar, Inc. (NASDAQ:FSLR) is doing well for the time being, but the improvement in its competitors’ cost structure and efficiencies are causes for concern. It has been able to weather the downturn due to large projects, but its falling cost advantage spells trouble for the next downturn.
SolarCity is a very promising investment whose leasing model will help to create relatively stable cash flow. SolarCity holds the most potential because unlike manufacturers, it benefits from volatile and falling panel prices. It is best to hold off investing until SolarCity becomes profitable, but right now, it is a good company to keep a close eye on.
The article Is Solar a Speculator’s Paradise? originally appeared on Fool.com and is written by Joshua Bondy.
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