The PV Module Supply Glut

Plenty of Money

Today, it's clear that financing is back. I recently attended the 8^th Annual Renewable Energy Finance Forum-Wall Street (REFF), co-hosted by the American Council on Renewable Energy (ACORE) and Euromoney Energy Events.  At REFF, the room was packed with financiers ready to fund PV projects with credible developers and quality off-takers, such as utility Power Purchase Agreements (PPAs), solar and wind developers, and attorneys ready to draw up deals between them. Notably absent among attendees were any utilities or other large power buyers.

I find the absence of power buyers telling.  Yes, there are utilities, businesses, and institutions signing PPAs with renewable energy developers, but it's a sign of the end-customer's market power that they don't need to come to networking events like REFF Wall St to get the word out.  Brian Matthay, VP Environmental Finance at Wells Fargo sees the distributed solar PV market as limited not by the supply of panels or finance, but by the lack of good deals.  For Wells Fargo, a good deal requires a quality developer, with experience and a strong balance sheet.

Wind is following a similar pattern.  According to Pat Eilers, Managing Director at Madison Dearborn Partners who spoke at the conference, the locations of new wind projects in the US is driven more by the availability of PPAs than the wind resource.  I even met a wind developer who is following a new model because of the lack of PPAs with favorable pricing, his firm is building wind farms to sell electricity into the spot market: They don't intend to sign a PPA until pricing becomes more favorable.

Plenty of PV Modules

Meanwhile, PV module supply continues to grow rapidly.  According to BNEF's projections, even an optimistic projection for PV demand is likely to fall short of supply in 2012 and 2013.

We last had a PV module oversupply in 2009, after the financial crisis destroyed many customers' ability or willingness to borrow leading to a rapid fall in demand.  Prices promptly fell, which in turn lead to a rapid resurgence in demand.  After falling short in 2009, demand slightly exceeded supply in 2010.  In other words, over a period of about a year, PV demand has shown itself to be remarkably elastic and quick to respond to falls in the price of PV.

Potential Sources of Demand

I expect the current and projected glut of solar modules will create lower prices and a new demand boom.  BNEF's projections for demand in 2012 and 2013 will likely prove to be too conservative, although many PV manufacturers will be unable to make a profit at the lower price levels.

Market power will shift from solar manufacturers to solar customers.  The biggest winners are likely to be end users, who will be able to get solar installations for much lower prices than ever before, and those solar installers able to reach out to the new classes of customers.

Where will the demand come from? According to J Andrew Murphy, Executive Vice President of NRG Energy, it will come from the maturation of the industry. He sees a growing customer awareness of electricity and where it comes from, many more companies such as Wal-Mart, Google (GOOG), and Whole Foods are not only investing in distributed generation themselves, but presenting it to their shareholders and customers as a value proposition. Those stakeholders, seeing that value proposition then see the value in adopting distributed generation, which usually means PV.

If there is a profitable opportunity in solar stocks, it will be in the stocks of developers able to adapt to the needs of the new classes of solar customers drawn in by rapidly falling prices.  I believe that solar manufacturers see this, and that's why many are integrating vertically down the value chain by buying up solar developers, such as Sharp's (SHCAY.PK) acquisition of Recurrent Energy, and First Solar's (FSLR) purchase of NextLight last year.

A more recent development was the merger of two of the strongest regional solar developers, when Real Goods Solar (RSOL) agreed to merge with leading Northeastern solar integrator Alteris in an all-stock deal. As prices fall, typical customers are more likely to want a brand they can trust and a one-stop shop for design, build, and financing.  I expect solar integrators such as Real Goods that have a history of successful acquisitions should do well, along with strong local brands.  But that does not mean that Real Goods' current high trailing P/E of 38 is justified.  Solar integration is a low margin business, and growth from all-share acquisitions such as that of Alteris comes at the price of dilution of existing stock holders.  As I concluded in my recent survey of solar industry integration, the industry is more likely to produce steady cash earners than high-margin, quickly growing high flyers.

Conclusion

While I expect the downstream portions of the solar industry to be solid earners over the next few years due to the rapid growth of the industry, that growth does not justify paying high multiples for a low margin business. If I had to pick a solar stock today, I'd be more likely to opt for the higher margin vertically integrated manufacturers which are currently trading at depressed prices due to the current glut.  My colleague Garvin Jabush considers Wall Street's current hatred of solar stocks to be irrational. It's not that he thinks module prices will not fall, but that such a fall in prices is more than adequately reflected in stock valuations.  I'm inclined to agree. 

While Real Goods has only a 2.6% operating margin, and a 4.0% return on equity (ROE), it trades at a forward P/E of 11 based on 42% expected annual growth in revenue.  Among manufacturers, cost leader First Solar trades at an 11 P/E, but has a 28% operating margin and 19% return on equity, numbers which seem much better able to fund the 27% expected annual revenue growth internally.  Jabush's pick, LDK Solar (LDK), is also a vertically integrated manufacturer/developer, and has a forward P/E of a minuscule 2.9, based on no expected profit growth and 12% annual revenue growth, which can easily be funded by the company's 20% operating margin and 38% return on equity.

It's always useful to understand future trends in the market, but profits come from understanding the market's reaction to these trends, as well as the trends themselves.  Right now, investors seem spooked by solar manufacturers, even though many of these manufacturers have worked to integrate vertically along the supply chain making them less sensitive to shifts in market power along the supply chain.   

Too often, investors in Renewable Energy get carried away by a positive growth story, rushing to buy at any price.  This time, the opposite seems true, and it's the selling that seems to have gone too far.  I've never been a solar cheerleader, and have always been cautious about confusing the growth of the industry with opportunity for the existing companies.  Yet right now, many solar stocks seem priced for long term zero, or even negative growth.  That, to me, seems to be taking the case too far.

This article was originally published on AltEnergyStocks.com and was reprinted with permission.

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