Solar Stocks = Value + Growth

Normally investors in a fast growing sector like solar need to becareful of valuations becoming stretched. P/Es in fast growing sectorswill sometimes reach 2-3 times the market average.

Oddly for amarket where q1 2010 opened with fears of oversupply and a resultingprice war, demand exceeded expectations (100% year over year growth),prices remained stable and a "goldilocks" market ensued in whichvaluations for most solar stocks have contracted significantly. Withonly a few weeks left to the year, many solar stocks are selling at 6,8or 10 times FY 2010 earnings and 3, 5, or 7 times FY 2011 estimates.

One of two interpretations follow: 1) investors are correctly discountingan oversupply situation in 2011 (which the companies themselves do notsee) and prices will decline significantly faster than costs leading tomuch lower earnings in 2011 or 2) this is a unique opportunity to buyinto one of the fastest growing industries of the decade, at prices that deeply discount the value and growth potential of the sector.

While the future is inherently uncertain–an oversupply could occur, andinvestors need to watch this aspect closely–it seems that Wall Streetis overly pessimistic about solars, by projecting absurdly low futurestock valuations. Just on Friday an analyst at Wedbush downgradedSunPower (SPWRA then trading around $13/sh) and reduced their targetprice for SPWR from $11/sh to $7/sh. This came only a day after thecompany confirmed FY 2010 earnings guidance of $1.50/sh and provided FY2011 earnings guidance of ~$1.90/sh.

SPWRA is now trading around $12/sh, which means the company’s FY2010 P/E is 8 with less than 6weeks to go in the year. And its FY 2011 P/E is just above 6, despitethe anticipated 30% growth from 2010-2011. The company is also sellingat a discount to book value (P/B = 0.84). Yet the Wedbush analyst thinks the stock is 70% overvalued…(at $7/share the 2010 P/E would be 4.8and the 2011 P/E would be 3.6 and the P/B would be under 0.5). Suchpessimism strikes me as extreme given the current rapidly growing solarmarket.

Another stock that I follow is LDK Solar which is aChinese solar play. The company is projected to earn $2 in 2010 andmaybe $4 +/- $1 in 2011. LDK trades just a little above $11/share,meaning its FY 2010 P/E is already near 5.5 and its FY 2011 is around 3. I could imagine this valuation on a company that is in serious troubleor embarking on a major restructuring, but not on fast growingprofitable companies. Something is out of kilter, and I say its the lowvaluation!

With the exception of thin film leader FSLR, which istrading at a market multiple, nearly every solar I know of is trading at a substantial discount to the market P/E, yet their revenues andearnings are projected to grow at least 30% in 2011.

The aboveearnings estimates are predicated on solar panel prices dropping ~10% in 2011. This means that price drops significantly greater than 10% couldnegatively impact these stocks earnings (although P/Es at 1/3 to 1/2 the market multiple somewhat reduce the downside to stock prices). SinceGermany currently installs about 1/2 of all solar panels in the world,the German market support (Feed-in-tariff) is especially important tosolar companies. They are set to reduce their FIT 13% in 2011–which iswell known in the industry.

While a 13% reduction may soundlarge, the country reduced its FIT by 26% in two stages in 2010 whichpartially explains why the Germans will install 2x as much solar in 2010 as in 2009, as companies rush to install panels ahead of these FITreductions. Assuming Germany leaves its FIT alone in 2011, I don’t seeany cause for panel prices to drop more than ~10% in 2011 (b/c theeconomics would be similar in both years for the installers). If Germany were to announce an additional one time large cut to its FIT, thiscould depress panel prices (although first there would be a surge toinstall panels ahead of the extra cut). The larger the expected cut thelarger the rush. Another possibility that could depress prices is ifGermany were to cap the amount of solar at some value below ~10GW/year.Current estimates are for 7-8GW to be installed in 2010 so a cap of say8GW would imply ~zero growth for the largest solar market and that could put downward price pressure on other markets.

What can sometimes get lost in all this talk of earnings, estimates, and FIT rates is that the solar industry is growing quickly because it supplies safe,reliable and clean power (at a lower and lower cost each year) to aplanet desperately in need of exactly this.

Solar companies canbring down prices each year because they benefit from "economies ofscale" (it is cheaper to make, or install–per unit–1 million panelseach year than it is for half as many) and what is sometimes called"economies of learning" (the concept that you get better at doingsomething the more times you do it).

There will be stumbles andmisses whenever an industry is growing as fast as solar currently is:50% compound annual growth rates. The only thing investors can do ismake sure they buy into companies at valuations that balance the risksand rewards available. It seems to me that now is a rare opportunity(b/c of a flawed Wall Street consensus) to buy into a rapidly growingindustry at an exceedingly low valuation.



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