Description
Initial Summary
I am short SunPower (SPWRA). The stock is at $21.
It's up 30% since last Thursday's close at $16.12 because French oil giant Total (TOT) is
buying 60% of both their Class A and Class B shares for $23.25 cash in a friendly tender
offer that commences next week and is planned to be completed by early June.
After the tender is complete, and I don't know why a long holder wouldn't tender,
40% of the shares will still be publicly traded. At that point the stock should be free to find its
way to a valuation based on the merits. TOT will be subject to a standstill that prevents
it from meaningfully increasing its ownership stake for several years.
The risk/reward profile looks asymmetric to me, so I am also writing at the money
calls. The TOT bid represents the maximum downside for a short position, but I believe
the stock is worth ~$12 1/2 for profit potential of 40%.
Let's talk about its unaffected valuation first. I'll come back to the TOT deal later.
Valuation
To invert T. Boone Pickens's famous quote about it once being cheaper to drill for oil on
the floor of the NYSE than in the oil patch: it's more expensive right now to buy solar
cell manufacturing capacity on the Nasdaq than it is to go out and build it yourself.
The sell-side, conditioned from the economic profits the industry earned during the
salad days of 2007-08, still values solar companies on metrics like growth and
earnings multiples even though First Solar (FSLR) is the only participant clearly and
consistently earning its economic cost of capital.
That valuation approach misses the forest for the trees. Solar panels are commodities.
With few exceptions the customer makes purchase decisions based on who has the lowest
price.
Capacity-driven commodity manufacturers should not be valued above replacement
cost of their capacity, plus net working capital, on a sustained basis unless there is a
barrier to entry, or unless there is an ongoing supply shortage that drives pricing to a level
based on what the product is worth to the customer rather than cost of production plus a
fair margin.
There is no barrier to prevent new entrants from adding capacity in this industry. One of my
high school's rival football teams had a chant they would do when they huddled up. RA! RA!
It stands for Reckless Abandon. Lame, I know, but how else to describe an approach
that races to add capacity and rapidly grow businesses that earn less than their cost of capital?
Goldman sees global manufacturing capacity growing from roughly 10,000 megawatts (MW) in 2008
to 40,000 MW in 2012, with utilization rates running at approximately 70% in 2010, 65%
in 2011, and 65% in 2012.
SPWRA's average utilization rate in 2010 was 72.8%, excluding panels produced by a
third party under the Serengeti brand.
The direction of solar module pricing doesn't indicate any kind of scarcity premium.
UBS has the following estimates for global solar module ASPs going forward...
- 2010: down 28%
- 2011: down 17%
- 2012: down 15%
SPWRA's ASPs were down 15.7% yoy in Q4.
Another factor driving ASP declines is that long-term procurement contracts for supplies
of polysilicon (the key ingredient for ~3/4 of global production by MW) struck a few
years ago when spot prices were hundreds of dollars per kilo are rolling off, and current
spot prices of well under $100 per kilo are starting to flow through the industry's cost
structure.
The solar industry's economics are generally unattractive; certainly worse than what
other capacity-driven commodity producers like fertilizer and cement makers experience
through the cycle, let alone at the peaks of their recent cycles when several were
producing good enough results for investors to value them at or above replacement cost.
FSLR uses Return on Net Assets (RONA) to describe their economic performance. I like
that metric because it penalizes industry participants for all the cash they keep on their
balance sheets. With much of the solar manufacturing industry trading above replacement
cost you might expect to see returns in the 30-40% range like what Terra Industries or
Potash were generating back in 2007-08.
With the exception of FSLR, the industry, including SPWRA, are delivering RONAs
below 10%. It'd be hard to argue any of these companies have a cost of capital
below 10%.
SPWRA's LTM RONA is 5.8%. 2011 is off to an undistinguished start with weaker than
expected Q1 results announced simultaneously with the TOT deal.
In spite of the absence of conditions that would lead a rational person to pay a premium
to replacement cost of capacity, let's consider a valuation of SPWRA on that basis.
Keep in mind this is the upper bound of what the business should ever be worth unless
permitting for new cell manufacturing facilities in places like Malaysia suddenly becomes
impossible or unless there's a sharp and sustained increase in the price of polysilicon.
SPWRA's year-end production capacity stood at 590 MW. Replacement cost of their
current capacity is roughly $472 million (590 MW * $800 million/MW). Net working
capital (NWC) at Dec. 31 was $1 billion. Therefore the enterprise has a maximum
value of $1.472 billion currently.
Net debt was $121 million after reducing gross debt of $840 million by both the restricted
and unrestricted cash. I reduce net debt by the restricted cash shown on the
balance sheet at Dec. 31 because the deal with TOT will enable them to free up much or
all of their restricted cash going forward.
Residual equity value of $1.35 billion on 98.2 million shares = $13.75 per share.
However, they also own 19.4 million shares (31.3% stake) of a publicly traded
monocrystalline silicon ingot manufacturer from Korea called Woongjin Energy (ticker
A103130). SPWRA participated in its formation in 2006 and the company went public
on June 30, 2010.
The stake is held in Other Long-Term Assets on the balance sheet, and is accounted
for using the equity method, with a carrying value of $76.6 million at year-end.
The current market price of the stock is KRW 16,100. On the current exchange
rate of KRW 1,082 per USD the stock is priced at $14.87 per share, so SPWRA's
19.4 million shares are worth $289 million, or $2.95 per share of SPWRA when divided
across the 98.2 million share count.
$13.75 + $2.95 = $16.70, or 20% less than the current quote of $21.
***
A more realistic way to think about what SPWRA is worth is by returning to one of the
fundamental tenets of valuation; the premise that a company earning an ROE above its
cost of equity is worth more than the book value of its equity, and a company earning an
ROE below its cost of equity is worth less than the book value of its equity.
After a huge Q4 the company's LTM return return on tangible equity stood at 28.1%. The LTM
number at Q4 overstates their normal earnings power given that until Q4 their highest
ever rolling 12 month return on tangible equity was 13.3%, at the end of the industry's
heyday in 2008.
As further evidence that a 28.1% ROE overstates their earnings power, the midpoint of
the company's 2011 GAAP EPS guidance is $0.80. Tangible book value per share at the
beginning of the year was $12.68. Assuming 100% earnings retention, tangible book
value at the end of the year would be $13.48, for an average tangible book during the
year of $13.08. On that number, 80 cents of GAAP earnings works out to a 6.1% ROE.
Using Ibbotson's long-term equity risk premium of 6.7%, the current 10-year Treasury
yield of 3.2%, and SPWRA's beta of 1.98, their implied cost of equity is over 16%.
That cost of equity is certainly higher than the 6.1% ROE implied by the company's
2011 guidance, their peak ROE of 13.3% during the boom, or the following ROEs
implied by the Street's GAAP earnings estimates, assuming 100% earnings retention.
- 2011: 6.2%
- 2012: 9.7%
- 2013: 15.3%
Therefore the stock should be worth no more than tangible book value of $12.68
per share, representing 40% downside from the current quote of $21.
What about the Woongjin Energy stake?
Since it's accounted for using the equity method, SPWRA's share of Woongjin's
expected earnings (found in Equity in Earnings of Unconsolidated Investees on the
income statement) should be in the GAAP earnings guidance. The carrying value
is already in tangible book, so it's receiving a multiple in the P/B valuation metric.
I considered trying to adjust 2011 guidance and current tangible book by backing out
Woongjin's financial impact in order to get a valuation for SPWRA's core business on
a standalone basis, then adding back the market value of the Woongjin shares.
However, it appears to me that SPWRA accounts for basically all of Woongjin's
revenues, so the two businesses are not really separable.
SPWRA's payments to Woongjin Energy for manufactured silicon ingots
- 2010: $183.6 million
- 2009: $152.3 million
- 2008: $52.7 million
Woongjin's revenues (in USD, per Capital IQ)
- 2010: $143.0 million
- 2009: $102.0 million
- 2008: $53.6 million
I don't know how to reconcile the two sets of numbers given that SPWRA's payments
exceed Woongjin's revenues. Maybe some of the SPWRA payments haven't been
recognized as revenue yet and show up on the liability side of Woongjin's balance
sheet as deferred revenue or customer advances, but I don't see any such balances
there. I don't read Korean so I can't read the notes in the annual report.
***
Industry producers seem to think that if they just keep growing, eventually the levelized
cost of electricity (LCOE = the all in cost; capital costs, energy costs, operating costs)
will reach grid parity with conventional sources of generation, capacity will get
rationalized and the pot of gold at the end of the rainbow will be big enough for the
survivors to make all the pain worth it.
Looking out a few years, IHS CERA sees the LCOE for best in class solar farms
dropping to 16.8 cents per kilowatt-hour (kWh) in 2014 from 21.4 cents in constant 2009
dollars. That still doesn't compare well on pure economic terms to thermal generation
like combined-cycle gas turbines (CCGT) that produce electricity for under 10 cents/kWh.
Also around the same time, GE should be entering the mix by bringing online the
400 MW thin-film production facility it recently began developing.
The competition just doesn't go away. But let's pretend it does, and that by 2014
the industry's economics will be attractive enough to justify valuing the surviving producers
at the replacement cost of their capacity.
SPWRA plans to have 2,050 MW of annual production online by then. Valued at $800 million/
MW in 2011 dollars, that would value its capacity at $1.64 billion. Adding the $1 billion of NWc,
taking out net debt of $121 million, and dividing the residual equity value of $2.52 billion
by 98.2 million shares = $25.65 per share.
$25.65 + $2.95 for Woongjin = $28.60 per share in 2011 dollars. A lot has to go right to
lose money by shorting this stock at $21.
I'm glossing over the potential of the TOT deal to enable further manufacturing
capacity expansion, access new markets, increase balance sheet capacity to enable
development of entire portfolios of commercial projects to a scale that's worth banks'
time to provide sale-leaseback financing, procure cheaper polysilicon, etc., but I doubt
those positives will be enough to offset all the negatives I'm ignoring in the $28.65 valuation.
Deal with TOT
SPWRA is not cost competitive on average and they are in a knife fight with Chinese
producers who don't seem concerned with accepting uneconomic returns on investment.
Q4 total cost per watt for three big Chinese companies (Suntech, Trina and Yingli),
market leader FSLR, and SPWRA...
- FSLR: $0.75
- TSL: $1.16
- YGE: $1.16
- STP: $1.48
- SPWRA: $1.71
SPWRA's claim to fame is the higher efficiency ratios of their panels (the percentage of light
hitting the panel that actually gets converted to energy). They're on the high end at 22%.
FSLR is on the low end at 11.6% (in the lab) because they use thin-film technology instead
of polysilicon.
Unless you adjust for the different efficiency ratios the cost per watt comparisons are a bit like
comparing apples and oranges, but the Chinese producers have efficiencies that are in the teens
and climbing. In any event the cost differences aren't close enough to have the gap between
SPWRA and the rest closed by simply adjusting for efficiency. Consider that FSLR's Q4 ASP of
$1.63 per watt was lower than SPWRA's average cost.
Plus, SPWRA has higher balance of systems costs - the boring equipment needed to
support the installation - partly because their panels, more so than others I hear, respond
most favorably to equipment that allows the panels to rotate and follow the arc of the sun
as the day goes by, as opposed to cheaper fixed installations where the panels face the
same way all day long.
SPWRA's other claim to fame is they have their fingers on the solar plant construction process
through the entire value chain, from manufacturing ingots all the way downstream to development
and installation by the dealer, whereas Chinese producers just sell their components to
middlemen. It's nice to have that high touch service level, but it's not apparent in the
reported financial results that the market, on average, is willing to pay up for it.
***
The industry is becoming more capital intensive.
The polysilicon-based producers are vertically integrating upstream in order to make their
on polysilicon and avoid getting caught in shrotages like they did a few years ago.
The industry is also expanding downstream, beyond unit sales of modules, into project
development in an effort to stimulate the sales outlet. Expanding downstream (tying up
capital in project development in order to serve up the panels to your customers on a platter)
seems like an obvious sign of weakening economics to me, but nobody appears to care.
Low cost leader FSLR has a big enough balance sheet and flashy enough stock price
to mostly self-finace their project developments.
The Chinese producers (half of global production) have access to cheap state loans.
For example, China Development Bank Corp. agreed last year to loan YGE over
$5 billion, to loan STP $7.4 billion, and to loan TSL $4.4 billion.
These dynamics leave SPWRA with a serious need for capital if they want to compete.
That's why SPWRA needs TOT's AA- rated balance sheet.
But why does TOT need SPWRA? The best explanation I can come up with is they
simply want a reputational hedge against their core business of E&P and refining
and they want a diversification option against falling production due to peak oil.
They're trying to put a more dynamic face on the company, and there are some
potential synergies between SPWRA and other minor investments they've made
in solar.
From what I read they seem to have a reputation for being somewhat erratic in looking
at investment opportunities outside their core business.
Keep in mind that while the $1.4 billion investment in a game changer for SPWRA
it's a drop in the bucker for TOT - their capex budget last year was over EUR 13 billion.
Nobody at TOT is going to lose their job if this doens't pay off in the next few years.
Philippe Boisseau, President of TOT's Gas & Power Division was apparently at SPWRA
last week to address the troops and talk about the deal. From what I hear, he described
the time horizon in terms of 5-10-20 years, almost as if it's a call option on the solar
industry's future growth potential.
Leaving 40% of SPWRA publicly traded has the side benefit from a PR perspective of
keeping more of a spotlight on TOT's involvement in solar than if it were absorbed
completely, and it also should help SPWRA maintain their culture more so than if the
company were absorbed into a giant bureacracy.
To expand on that, the kind of person who goes to work at a solar company has a
different set of ideals than the kind of person who goes to work at an oil company.
When the TOT deal was announced last week SPWRA employees were e-mailing
around videos and articles about TOT, highlighting stuff like human rights violations
in West Africa. There's a bit of grumbling, but nothing like the unrest that might
happen if SPWRA's green identity was absorbed completely into TOT.
Leaving 40% publicly traded also maintains the option of being able to use
comparatively overvalued SPWRA shares rather than cheap TOT shares for
acquisitions.
Owning 60% effectively gives them the benefits of full ownership such as strategic
control without having to buy the whole company.
So how did TOT arrive at the implied $2.3 billion valuation? SPWRA was asked about
that on the conference call. Here's what their CFO said...
"I think Kelly, like most long-term investors that -- like Total, they do look a lot at the discounted
cash flow value of the company. And I think given their global footprint, the markets that they're
in, the long-term perspective they have of how solar is going to play in those markets over the
decade, they obviously looked at where we were trading today in order to look at the premium. But
I think it really has more to do with how they can help us grow faster in markets where we weren't
at and what value are they bringing to the table?"
I'm not seeing a striaght answer in that response. It may just be a coincidence, but
SPWRA's cumulative capex from the time of their oldest publicly available cash flow statement
I see (2002) is $928 million in nominal dollars. Cumulative R&D is $146 million.
Combined that's $1,073 million. Gross it up for inflation and that gets you in the
neighborhood of the $1,400 million TOT is spending.
However, as part of the deal TOT will turn around and buy the 50% of solar panel maker
Tenesol from EDF that they don't already own, and then sell the whole thing to SPWRA
for $167 million. Whether the consideration is cash or stock is yet to be decided.
I don't know if the $167 million is for Tenesol's equity only, or if it includes the
assumption of debt. It's probably not a big distinction though. The most recent financial
data Capital IQ has on Tenesol is from 2009. At 12/31/09 Tenesol had common equity of
EUR 63.8 million and net debt of EUR 14.4 million.
Is it a fair price? More or less I suppose. It's not insane. Tenesol's trailing net income
was EUR 6.5 million on revenues of EUR 238.9 million. Assuming the purchase price of
$167 million was for the equity only, and applying the current exchange rate of
$1.48/EUR, it represents 1.77x book and 17.4x earnings.
TOT will net half the $167 million, or $83.5 million, so their net investment in SPWRA
comes down to just over $1.3 billion.
So, they could spend $1.1 billion+ to recreate over time a business that SPWRA has
already built, or they could pay a slight premium to that and get control of the business
now. Seems like an easy decision if you're bent on going solar.
***
At this point you're probably wondering about the probability that TOT buys out the
remaining 40% of SPWRA and ruins the short thesis.
TOT will be subject to a standstill agreement that sets limits on their ability to increase
their ownership over the next few years.
- 63% until 2 years after closing
- 66.7% between the 2 year mark and December 31, 2014
- 70% starting January 1, 2015
That's ample time for my short thesis to be proven right or wrong by the business.
The termination fee from SPWRA to TOT would be $42.5 million, or 3% of the gross
value.
The potential for shareholder dilution related to SPWRA's convertible bonds is
limited, so I am not counting on it.
They have 4 convertibles outstanding with par value of roughly $680 million. Only
2 have stated conversion prices near the current market price of $21, but they
are unlikely to create dilution because of hedges the company put in place to
raise the effective conversion price.
The 4.75% issue of 4/15/14 has par value of $230 million and a stated conversion price
of $26.40. The hedges in place raise the effective conversion price to $38.50.
The 4.50% issue of 3/15/15 has par value of $250 million and a stated conversion price
of $22.53. The hedges in place raise the effective conversion price to $27.03.
Odd Stuff in the Offer to Purchase Filing
There are some interesting tidbits in the Offer to Purchase filed May 3. I'm not sure how
to connect all the dots, but I think they at least speak to the way SPWRA is run.
First, Peter Aschenbrenner is SPWRA's VP of Corporate Strategy. As described in
Section 11 (Background of the Offer, Contacts with SunPower) he played a key role in
the deal process.
What's interesting about him is that from April 1994 through March 2003 he was the VP
of Global Operations for AstroPower, a company that was eventually sold to GE out of
bankruptcy after a series of scandals. He later joined SPWRA.
In January 2007 SPWRA filed an 8-K on the topic of an unrelated acquisition which
contained this nugget...
"By letter dated December 12, 2006, the SEC enforcement staff notified Peter Aschenbrenner
(in what is commonly referred to as a "Wells Notice") that it intended to recommend that the SEC
take legal action against him. The Wells Notice alleges that Mr. Aschenbrenner played a role
in AstroPower, Inc.'s allegedly improper recognition of revenue and that Mr. Aschenbrenner
committed insider trading."
In light of that news, SPWRA at the time stated he would no longer be at the executive
level of the company (to get him off their D&O policy?), yet here he is 4 years later leading
a transformative deal for thecompany. Howard Wenger, SPWRA's President, Utility & Power
Plants is also an AstroPoweralum.
Second, the Offer to Purchase includes some bizarre financial forecasts. On February 9, 2011
SPWRA provided bankers with an "Initial Forecast" for 2011 and 2012.
2011 2012
Revenue $3,125 $4,910
Gross profit $683 $1,127
EBITDA $460 $819
EPS $2.46 $5.25
2012 top line growth of 57% yoy and EPS over $5 would be most impressive.
However, on April 13 "representatives of of Deutsche Bank provided a revised forecast
based on assumptions that SunPower management believed more accurately reflected
SunPower's prospects in light of events that had recently occurred." (emphasis added)
2011 2012 2013 2014 2015
Revenue $2,850 $3,715 $4,183 $5,444 $6,960
Gross profit $642 $715 $870 $1,111 $1,434
EBITDA $420 $511 $620 $779 $1,037
EPS $2.03 $2.58 $3.35 $4.13 $5.45
The new forecast is called the "Management Case".
Let me get this straight - something happened in that 2 month window that caused
management to believe their 2012 revenue forecast was off by $1.2 billion, to believe
their 2012 gross profit forecast was off by $412 million (implying a gross margin on
those lost sales of 35%, for a company that never did better than 28% on a roling
12 month basis), and to believe their 2012 EPS forecast was off by 50%.
This, for a participant in an industry that is keenly focused on managing a tricky
supply chain.
(The EPS numbers in general seemed particularly gaudy until I realized they must
be "core" numbers that SPWRA is famous for. On a diluted basis, over the last 4
full fiscal years the company reported cumulative GAAP EPS of $3.26 and cumulative
"core" EPS of $6.41, for a "core" overstatement of GAAP EPS by 97%.)
A normal investor might want to know what events occurred during the 2 month
window to cause such a dramatic change in forecasted performance.
The Q4 earnings press released dated February 17 might be a good place to start.
As it runs out, the release contained 2011 guidance.
Revenue: $2,800 - $2,950
Gross margin: 20% - 22% (non-GAAP)
Diluted EPS: $2.00 - $2.20 (non-GAAP)
Diluted EPS: $0.70 - $0.90 (GAAP)
Those numbers look pretty similar to the Management Case dated April 13 and, true
to form, diluted EPS guidance on a GAAP basis is dramatically lower than guidance
on a non-GAAP basis.
So, the wildly bullish Initial Case was provided on February 9, but more sober guidance
that appears to form the basis of the Management Case was released just 8 days later.
I'm not sure what could have changed during those 8 days. Solar stocks generally rose.
SPWRA didn't have any press releases or file any 8-Ks. Maybe there was a change in
expectations for one of the European markets, where the game is generally more about
component sales, as opposed to entire systems end-to-end. Components alone
have higher margins, which might explain why the reduction to the revenue forecast had
such a high gross margin.
Maybe these issues just speak to a culture of lax controls. This is the same company that
had accounting issues in its Philippine manufacturing operations in 2008-09. I guess
where it leaves us is this is not a company I would want to give my money to.
Closing Thoughts
There are important issues for the industry that I haven't explored in this writeup.
- Direction of polysilicon supply/demand
- Outlook for tax and feed-in-tariff (FIT) subsidies
- Renewable portfolio standard mandates
- Cap and trade prospects
- Development of commercially scalable storage for electrical energy
- Transmission and grid limitations on adding solar
- Potential impact of a Chinese economic meltdown
At $21 per share the stock is nearly priced for perfection - a 25% premium to replacement cost
of $16.70 and a 65% premium to tangible book value of $12.68 - so I don't think I have
to get the near-term issues on the list right in order to make money.
The real game changer that would blow up the short like nothing else is commercially
viable electricity storage, but that development isn't even on the horizon.
Consider 2 of Buffett's tests of business quality.
1. If you gave me $10 billion on the condition that I use it to try and build a business
that could compete with companies like Visa and MasterCard, Union Pacific, Martin Marietta,
or Southern Company, I couldn't do it. But, I could take that money and make life hell for SunPower.
2. In his recent interview with the Financial Crisis Inquiry Commission he had this to
say about his investment process.
"And basically the single most important decision in evaluating a business is pricing power. You've
got the power to raise prices without losing business to a competitor, and you've got a very good
business. And if you have to have a prayer session before raising the price by a tenth of a cent,
then you got a terrible business. And I've been in both and I know the difference."
If SPWRA tried to raise prices by a tenth of a cent they'd have to have a prayer session.
There's also the thought exercise Buffett proposes before buying a stock - pretend that when
making the investment you know the exchange will close tomorrow and you won't be able to
sell your stock until the exchange re-opens in 5 years. Do you still want to buy it?
I can't think of many companies with multi-billion dollar market caps I'd feel less comfortable
buying under those conditions than SPWRA.
***
So who's on the other side of my trade? I think it's people who are so captured by the
concept of green energy that they're unwilling to think about valuation outside the context
of narrow metrics like P/Es and revenue growth, or even pay attention to recent corporate history.
The older I get the more I realize how hard people work to keep their blinders on once
they become enamored with a theme, and avoid benefitting from the lessons of history.
In the case of solar, investors might do well to think about how the evolutionary stages of
other industries like railroads, automobiles, or the dot-com era worked out for investors.
Risks
- Sharp and sustained rise in polysilicon prices
- Unexpected industry discipline with respect to capacity
Catalyst
Completion of the tender offer