Why I Am Short First Solar $FSLR

first solar graph Why I Am Short First Solar $FSLR

Investing in technology stocks has lots of traps for neophytes — and by-and-large, we are neophytes so we do not do verymuch of it.  We do, however, spend a lot of time thinking about it,primarily because we are scared of what technology can do to otherbusinesses. The demise of many low-tech newspapers provides a gooddemonstration of why –- as investors –- we should think abouttechnology.

Technology offers a level of value creation that fewother industries can match. In Australia, Cochlear has created enormousvalue and improved the world. It can literally plug a bionic ear intosomeone’s brain stem and get them to hear. And the stock has paid about20X –- which is better than anything in our portfolio. Many of thebiggest fortunes were made in technology. But technology –- andspecifically technological obsolescence — has thrown many a finecompany to the wolves. Palm, for instance, is likely to go bankrupt even though the concepts it pioneered are still in everyone’s pockets.

We do, however, have a framework to hang around our (limited) technologyinvestments. A technology, to be a really great investment, must do twothings. It must change part of the world in a useful way (a big part ofthe world is better, of course, but you can be surprisingly profitablein small niches), and it must keep the competition out.

Intechnology, the competition is remorseless. In most businesses thecompetition might be able to do something as well as you — and it willremove your excess profit. People will build hotels, for instance, until everyone’s returns are inadequate but not until everyone’s returns aresharply negative. Even in a glutted market a hotel tends to have areason to exist — it still provides useful service. And someday theglut will go away so the hotel will retain some value.[1]  In mostbusinesses, the game is incremental improvement. If you get slightlybetter you can make some money for a while. If the competition getsslightly better, you will make sub-normal returns until you catch up.

In technology, the threat is always that someone will do somethingmassively better than you and it will remove your very reason forexistence. Intel’s Andy Grove, one of the most successful technologistsof all time, titled his book Only The Paranoid Survive.  Hemeant it.

If your technology is obsolete — the endgame isfailure, often bankruptcy.  Palm will fail because Palm no longer has areason to exist.  If we wait twenty years, Palm will be even moreobsolete — but the hotel glut will probably have abated. Nothing leftin Palm is likely to have any substantial value. Businesses thatproduced plenty now, will likely produce nothing then.

Surprisingly, changing the world looks like the easy bit. Plenty of companies do it.The problems are in keeping the competition out. Only a few do that(Microsoft and Google are some of the few that seem to). Hard drivemakers changed the world (they allowed all that data storage, which made things like digital photography and internet multimedia possible). Butthey never made large profits — and they trade at small fractions ofsales.

The limited technology investments we have made are notdriven by any real understanding of the technology. Sure, we try — butif you ask us how to improve the laser etching on a solar panel, then we will not be able to help. The driver of our investment theses in almost all cases is watching the competition.

A simple example isGarmin. We have a small short position in what is a very fine company.Garmin, once a small avionics company, led the mass marketing ofsatellite navigation and allowed John — without stress — to find hisson’s Saturday sports matches. Sat-Nav, it seems, has saved manymarriages and meant that school sports teams do not run short playersbecause Dad got lost.

Garmin has over a billion dollars cash onthe balance sheet — and that cash represents past profits. It haschanged the world, and thus far it has been well remunerated.

The only problem is that they can’t keep the competition out. Nokia haspurchased a mapping company. Iphone now has a Tom-Tom app, downloadablefor $80 in Australia. Soon Sat-Nav will be an expected application inevery decent mobile phone. Google has mapping technology, too, and willsoon embed it into their Android phone. Eventually the maps will begiven away because people might book hotels using their Sat-Nav devicewhile they are travelling. (It is darn useful to know where a decenthotel with a vacant room is located when you are on the road.)

Garmin has a great product. They have improved my world. The only problem isthat they can’t sell their product at any price that competes with“free.” Garmin’s business is going the same direction as Palm.Bankruptcy, however, is only a remote possibility — they have a billion dollars on the balance sheet and unless they do something really stupid on the way down, they will remain a profitable avionics business.

Is it fair that Palm is facing bankruptcy? Or that Garmin is beingdisplaced?  We don’t think so; but then again, capitalism is notnecessarily moral or fair –- as a system, however, it does produce goods and services quite well. We don’t invest on the basis of fair –- weinvest to make good returns.

The solar industry – and the possible failure of the good

First Solar is a companythat improved the world. It has driven the cost of solar cellsproduction to quite low levels and made utility-scale solar farms viable with only modest subsidies. There are some places where solar is nowviable without subsidies.[2]

Our biggest short position, though,is First Solar -– a company for which we have little but admiration.There is a distinct possibility that First Solar’s business will fail in the same way that Palm’s or Garmin’s has. It won’t be fair –- butfairness has nothing to do with it. Like Garmin, First Solar probablywon’t go bust because it has a billion dollars in liquid assets on thebalance sheet –- assets which represent past profits.

Moreover,we suspect that First Solar’s profits are about the same as the rest ofthe industry put together. The stock still trades with a high-teenstrailing price-to-earnings ratio –- i.e., it’s a fading growth stock. It hardly looks like a failure. It is a strange conclusion to come to, sowe should explain how we got there. To do that we need to explain how asolar cell works.

How a solar cell works

To make a solar cell you need three things.

1). A substance whichis excited (i.e., spits off electrons) when a photon hits it.

2). A layer which separates the electrons. This layer is usually a“semiconductor” which means that electrons go through one way and cannot go back.

3). Something at the back which conducts the electronsaway.

Thin film versus wafer

Traditionalsolar cells were made with a semiconductor ingot cut to a thin sheet. On one side was “doped” with a substance that kicks out electrons. Theother side was laced with wires to conduct the electrons away. This wasexpensive.

There were generally two types of ingot:monocrystalline, in which the wafer structure is perfect or nearperfect, and polycrystalline, which has visible crystals in the wafer.Monocrystalline wafers are primarily used for computer chips (whereatomic level imperfections are problematic) and are expensive.Polycrystalline silicon is cheaper.

For most large-scale uses, polycrystalline wafers are sufficient.These have about a 17 percent conversion rate –- which means that 17percent of the photon energy that strikes them is turned intoelectricity.

The ingot itself was a substantial part of the costof a photovoltaic cell. Polycrystalline ingot used to sell for $450 perkg. [That was a spot, not contract price. - ed.]

First Solar (and others) developed a process for making solar cells with considerablyless semiconductor material. They have a cadmium telluride process which vapor-deposits a semiconductor at atomic-level thickness and comes upwith a cell that is now exceeding an 11 percent conversion ratio.

This company is a technological wonder. Glass goes in on one end of themanufacturing process and comes out as solar cells at the other withnext to no human intervention. Labor is used only when it comes toputting frames around the glass and for similar tasks.

This wasrevolutionary — it made cheap solar panels and hence made possiblelarge, megawatt-size commercial-scale plants. This is enough to supply a few hundred households — not earth-shattering, but it represents acomplete revolution in the solar industry.

We can think of fewother companies that have pushed a technology so far and with such highenvironmental benefits. Companies like this will allow us to maintain amodern lifestyle while addressing greenhouse emissions issues.

Still, for all the benefits of First Solar’s cells, they are inferior in manyimportant ways to a polycrystalline cell. Their efficiency is lower –which means you do not get as much solar energy off the constrained roof space. Secondly, while they save a lot on the semiconductor part of the manufacturing process they have to use more glass, more wires, etc., to generate the same amount of solar electricity. Each cell generates less electricity, as well, so inverters, connectors, and installations allcost more with thin film. Thin film also degrades over time. First Solar warrants their performance over their lifetime — but with the warranty accounting for lower levels of performance in the second decade ofoperation (Google the Staebler-Wronski effect for a non-trivialexplanation). Thin film does, however, have some advantages in lowlight, such as the ability to retain a slightly greater proportion oftheir peak capacity.

Indeed, the main advantage of thin film iscost — and that cost advantage has been driven by the cost of thesemiconductor component.  After all, ingot did cost $450 per kg at onepoint.

That cost advantage made First Solar absurdly profitable,and they have used that profit to grow into a behemoth. Revenue hasgrown from $48 million to over $2 billion. Gross profit (before sellingand administrative costs) has grown to over $1 billion. We do not wantto tell you how far the stock ran for fear of invoking insane jealousy.This stock would have made Berkshire Hathaway shareholders jealous.

But remember: all of that was predicated on a cost advantage (almost allother things being inferior). And that cost advantage is predicated onexpensive semiconductor material.

Competition cometh

To recap, in order to make money in technology, you need to do two things. First, you need to change the world (which First Solar clearly did),and secondly, you need to keep the competition out. Alas, very fewbusinesses manage the second trick.

In First Solar’s case, thecompetition has come in a couple of forms. First, it came from AppliedMaterials. Applied Materials, or AMAT (as the company is known), is themost important company in the world you have never heard of. It is thedominant maker of capital equipment that goes into semiconductorfactories and it is thus the company that, more than any other, provides the kit to keep Moore’s Law active.

AMAT has tried competinghead-on with First Solar in the thin film space. AMAT developed thevapor deposition equipment that made large-screen LCD televisionspossible. This entails deposition on large sheets (5.6 square meters),which are then cut down into several large screen TVs. An imperfectionin the vapor deposition shows on the TV as a bad pixel.

AMATappropriated this technology for solar. The silicon semiconductor is not as efficient as First Solar’s cadmium telluride technology and it isequally subject to the Staebler-Wronski effect; however, they can domuch larger panels than First Solar (with comparably lower wiring,inverter, and balance of system costs). AMAT’s thin film business coulddo some damage to First Solar, but it is unlikely to kill it. (Indeed,AMAT appears to be de-emphasizing that business for the reason discussed below.)

Far more important have been developments in the waferbusiness. AMAT (often the protagonist) has developed wire saws forcutting wafers into thinner and thinner slices. They are now 80 micronsthick. These wafers are so thin that they flutter down in the air andbreak if held on their side. AMAT will, of course, sell the whole kitfor handling these wafers -– including laser-etching material and theequipment needed for other steps in the manufacturing process. Much less semiconductor material is needed in the wafer business.

However, the price of ingot has fallen -– and spot prices are now $55 per kg, a lot less than $450. First Solar’s advantage is entirelydependent on the fact that they use much less semiconductor than wafers– an advantage that disappears entirely as wafer prices fall. At thatpoint, all of First Solar’s many disadvantages will begin to shinethrough.

We are trying to work out the cost-structures of thepolycrystalline manufacturers, but it looks to us that the extra glassand other balance-of-system costs that First Solar panels have are nowgetting close to completely removing the advantage of low semiconductormaterial usage.

If that happens, First Solar is toast. Itprobably won’t file bankruptcy, because it has so much in past profitsto fall back on, but it will be every bit as obsolete as a Palmorganizer is now or as a Garmin car-based navigation system might be infive years.

We do not wish failure on First Solar, and if we areright in this assessment, it could not have happened to a nicer company(no irony intended). Capitalism is not fair -– and technology investment is particularly unfair.

We don’t make money from fairness. Wemake money from getting the business analysis right and betting on (orbetting against) the right business –- and in this case we are bettingagainst the most successful company in a massively important growthindustry.

If we are right (and we think we are), then we willmake money from the demise of a company that has much improved theworld. We like to think our business is noble, and sometimes it is –but in this case, we can see why people dislike short-sellers. Theiropinion, however, is not our business.

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[1] Unfortunately, the hotel is usually mortgaged — andthe value often reverts to the debt holder.

[2] One way amuses us greatly. Walmart started putting solar cells on the rooftops of many of their super-centers in the southeastern United States. They did thisoriginally because of implicit subsidies. However, the test centersshowed something quite interesting. Good solar panels turn quite a lotof the energy hitting the rooftop into electricity that is conductedaway. That energy does not get turned into heat in the building, and assuch, the cooling load of the building went down. The rooftop solarinstallation may not have been justified by the electricity outputalone, but combined with lower cooling bills, it worked out great.

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Note: GTM analyst Shyam Mehta has threatened to write a piece on whyhe is short Bronte Capital.

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John Hempton is the Chief Investment Officer at Bronte Capital. He has extensive experience in global markets with Platinum AssetManagement, an Australia-based global fund manager.  John was the chiefanalyst for financial stocks globally and a partner in the business.  Amore extensive curriculum vitae can be found here.

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