In March, we lowered the majority of our fair value estimates across the solar sector, given our belief that solar supply and demand had become imbalanced and the stage was set for an industry downturn.
Results and deteriorating industry conditions (falling prices, inventory buildups, extension of payment terms) have confirmed that this is in fact occurring, and our solar coverage list has experienced material share price declines (see below).
However, we still believe solar stocks will fall further from here. Though a challenging near term is starting to be priced in, solar shares trade largely on near-term results and we believe the market is placing too much faith in a second-half rebound and the industry cycle bottoming out in the second quarter. Without question, global installation activity will increase in the coming months. But the fact remains that there simply is not enough demand for the industry to both reduce inventory levels and keep factories running at high utilisation rates.
The rumblings from the recent Intersolar conference (solar's largest) in Munich suggest that though demand is slowly improving, it is nowhere near enough to stop further pricing declines. In our opinion, global demand needs to be at least 23 gigawatts (GW) in order to keep pricing levels near where they are today ($1.40-$1.50 per watt for solar modules). We are forecasting 18.3 GW of installations will occur this year, which if accurate means the industry's troubles are far from over. As SunPower (SPWRA) CEO Tom Werner said when his company recently reduced its 2011 guidance, the problems solar is facing are structural in nature. Clearly, these are headwinds that will not be resolved in one quarter. We continue to view Renewable Energy Corporation (REC) and Suntech (STP) as overvalued names with near-term downside.
There are at least a few developments we anticipate will occur that are not yet fully baked into current share prices:
-- Module pricing will fall at least below $1.25 per watt by the end of 2011. In other words, margin compression will not stop in the second quarter.
-- Low-cost Chinese manufacturers, and possibly First Solar, will be forced to reduce production levels and incur negative operating leverage--and further margin hits.
-- Inventory write-downs will occur across much of the industry, with potentially only the lowest-cost producers being spared.
Despite our extremely bearish near-term view, the fact remains that solar still has a very promising long-term future. Eventually, industry fundamentals will improve as balance returns to supply and demand. Once share prices near their bottoms, we think investors should be targeting well-run companies with leading cost structures and strong balance sheets. The two companies that clearly fit such a description are First Solar (FSLR) and Trina Solar (TSL). Although share prices for both companies have materially declined, we believe the near-term industry headwinds are severe enough that more attractive entry points are likely to present themselves before shares bottom out.
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