Saturday, December 18, 2010

Rule #1 Analysis Blitz #6: First Solar (FSLR)

I'm back!  After being sick for several weeks, I am now pretty much fully recovered.  It appears that the flu virus is especially strong this year.  I know a couple of people who took about 2-3 weeks to recover.  It really teaches one not to take a good healthy body for granted!

Up until now, I have analyzed both good and not-so-good companies in my Rule #1 Analysis Blitz.  What I have not included were stocks that I actually owned.  Obviously, I try to follow my own rules and buy only stocks that pass my own requirements.  So, first up, First Solar, my favourite solar panel manufacturer.  I've talked about this stock before, but never really showed you my analysis.  So, here it is, my Rule #1 analysis on First Solar (FSLR).

Before I begin, a useless random fact...the panels in the image I used above are not First Solar panels.  How do I know?  The give-away is in the texture of the solar cells.  You can see small dots of brighter reflection, which indicate that these cells are made from polysilicon.  As you'll soon find out, one of the reasons First Solar is doing so well is precisely because it doesn't use silicon to make its solar panels.

Some Background on Solar Panel Technology
Solar photovoltaics have been around for many decades now.  First, what are they?  They are solar cells that convert light into electricity, just like those found on your handheld calculator.  I can't remember when solar cells began to power them, but they were definitely around when I was a kid in the 80s.  Although solar photovoltaics have been around for a long time, their cost have been prohibitively high to be used to generate electricity on a large scale...until now!

There are 2 major types of photovoltaic cells: traditional crystalline silicon and thin-film.  The majority of solar panels produced today uses the traditional silicon technology.  Manufacturers take silicon, melt it down, and form a large silicon rod, called an ingot.  The ingot is then sawed into thin pieces of silicon wafers.  The wafers are fractions of a millimeter thick.  So, if you imagine that you had to cut a loaf of bread into very thin wafers, you will waste a lot of bread because you knife is thick and you'd cut off a lot of crumbs.  This is effectively what happens when the sawing occurs.  These thin wafers are also very fragile and often break during the subsequent processes that includes soldering wires onto them, laminating them between two pieces of glass, etc.

The thin-film technology is a much more streamlined process.  Instead of forming a large ingot and then cutting it into thin pieces, a large glass panel is the starting point and the semiconductor compounds are deposited onto the glass using vapour deposition.  The layer of semiconductor is less than 0.050 mm thick, compared to a silicon wafer of about 0.200 mm thick.  This technique also wastes very little of the semiconductor, unlike the sawing process for silicon wafers.  In short, the thin-film technology is significantly cheaper than the tradition silicon process.  One downside is that the efficiency of the cells, how much sunlight gets converted into electricity, is lower.

First Solar is arguably the most successful thin-film solar manufacturer in the world.  Applied Materials, which began selling thin-film "factories in a box", a few years ago have effectively ended their solar business.  The largest solar players out there now, Q-Cells, Suntech (Ticker: STP), Trina Solar (Ticker: TSL) all use traditional silicon technology.  Sharp Solar is pretty much the only thin-film manufacturer out there that is comparable to First Solar.  First Solar is the lowest cost manufacturer in the world at $0.77 per watt.

You can download the completed Rule #1 spreadsheet here.

Before we begin, we should note that First Solar is a relatively new company.  It was founded in 1999 and became a public company in late 2006.  In normal instances, Rule #1 investors look for companies with a longer history that is consistent.  However, I made an exception just because I think First Solar is a great company.  Let's take a look why that is the case.

The first few years of the companies are really irrelevant, in our case.  It was a startup and management was just trying to figure out things like developing its product and build factories.  It was a time of expansion and rapid consumption of capital.  So, let's take a look at its more recent history

The Big 5 numbers in the summary table is not of much value this time, because the longer term numbers are fairly inconsistent.  I've added a second figure with sales, EPS, BVPS and free cash flow numbers of the past 10 years.  Just taking a glance of these numbers for the past 4 years, you can see that there is explosive and consistent growth in pretty much every category.  The only concern is that free cash flow has been a little inconsistent.  However, there is a good explanation for that.  If you look at cash from operations, the growth has been very steady.  The only thing that is hurting free cash flow is capital expenditures, which is essentially the cost to increase production capacity or building new production lines.  That is expected of a company that has expanded production to more than 1 GW of solar panels sold in 2009.

The moat that First Solar has is in its cost structure.  Because of its successful thin-film technology, cost per watt has gone below $1.00 per watt, which has not been achieved by any other solar manufacturer.  And this was achieved by First Solar back in 2009!  Other Chinese manufacturers are gettting close to this $1/W milestone, which is thought by many as the grid-parity value (i.e. the cost of panels to make cost of solar energy to be the same as traditional energy generation methods).  This is very important because solar panels are essentially commodity items.  Like potatoes or oranges, customers don't really look for brands of these products and their buying decision is largely based on the cost of these items.  If you look at Walmart, the world's largest retailer, it sells commodity-like items but at a cheaper price than most other competitors.  Its cost moat is the reason why they have been so successful.

The demand of solar products is currently so high that other less efficient manufacturers can still sell their products at a profit.  As solar supply increases, the selling price of panels will decrease.  Inefficient manufacturers will either need to decrease margins and potentially even sell at a loss or risk not selling any panels at all.  There will be a fallout of these companies.  What will eventually happen is that a few larger players will survive during this consolidation of the industry.  First Solar is in a good position going forward.

Because solar panels are commodity items, unless First Solar continues its leadership in low cost manufacturing, it will lose out to other manufacturers.  There is no reason why customers would want to buy First Solar panels if theirs were more expensive.  For this reason, it gets a couple of points docked off for Moat.  It gets an 8 out of 10.

Moat Score: 8 / 10

Figure 1: Rule #1 Analysis of First Solar (FSLR)

Figure 2: Rule #1 Analysis of First Solar (FSLR) - Continued

Margin of Safety
First Solar has been growing EPS at greater than 50% in the past few years.  For 2010, it will likely slow to about 20%.  There has been a lot of concern about shrinking margins at First Solar, but I believe these fears are overblown.  In any case, I believe EPS growth can probably continue at the analysts' estimates at about 23%.  The historical P/E ratio of 19.4 was used.  These assumptions give us a sticker price of $277 and entry price of $139.  The stock sits at $135 at time of writing.  It looks like we have adequate margin of safety to buy this stock.

Because of its high estimated EPS growth, payback time is a mere 7.2 years.  I'm really liking this!

Since the EPS estimates are fairly high at 23%, I will take a few points off.  First Solar gets a 7 out of 10 in Margin of Safety.

Margin of Safety Score: 7 / 10

Robert J. Gillette is the current CEO of First Solar.  He's only been at the helm for a bit over a year, replacing Michael Ahearn.  Prior to leading First Solar, Gillette was CEO of Honeywell's Aerospace division, which was the largest division in the company.  Gillette has a pretty good track record.  After a year as CEO, Gillette continues to drive growth at First Solar.  He has plans to expand capacity to 2 GW by end of 2011, which is nearly double of what it is in 2010.

Since his tenure at First Solar, Gillette has bought 10,000 shares of First Solar at $104.63.  The stock now sits at $135.  It is usually a good sign when an incoming CEO buys a significant amount of shares.  He is putting his money where his mouth is.  I remember when the CEO of my company, ATS, Anthony Caputo came onboard, he bought a large number of shares.  Since his arrival, our stock has risen from under $4 to about $7.

In a recent conference call, Gillette explained that the company's goal is to seek long term growth, which means that margin contraction would likely occur.  Why is that?  They must price their products accordingly to achieve market penetration.  Many times, companies that are first to market gain a large percent of market share.  Ebay is a perfect example of this in the online auction business.  The riskier and the correct path for the company would be to make investments up front.  As I mentioned above, the industry will go through a consolidation phase as the technology progresses.  That has already begun to happen.  My prediction is that smaller, non-profitable players, like Evergreen Solar (Ticker: ESLR), will go bankrupt within a few years.  As long as earnings continue to grow in absolute terms at First Solar, I believe a little margin contraction is not an issue at all.

I give Gillette an 8 out of 10.

Management Score: 8 / 10

First Solar has tremendous meaning to me.  As long as I could remember, I found renewable energy very interesting.  In my highschool days, whenever I had science projects, I would pick topics like fuel cell technology, automotive hybrid technology, etc.  I foresee a future of clean and sustainable energy for the world.  It is only a matter of time before that happens.  Our generation is just like that of 100 years ago.  We are going to see a whole paradigm change.  100 years ago, the automobile changed the lives of everyone on the planet.  100 laters, sustainable energy will be that life-changing technology.

We are also stewards of this Earth.  We are now at a stage where if humanity continues its path of burning fossil fuels, we will destroy not only our environment, but civilization itself.  Investing in renewable energy is one of the more ethical decisions you can make financially.

First Solar has a number of manufacturing plants in Malaysia and Vietnam.  Many people think of sweatshops when Asian factories come to mind, but if you have every visited a photovoltaic manufacturing facility, you would think you have entered a futuristic world.  The working conditions are clean and brightly lit, and operators have to been in good working conditions since product quality is of top concern.  Sweatshops and photovoltaic manufacturing facilities could not be any farther apart in the spectrum of manufacturing plant conditions.

Solar energy will drive the economy in the coming future.  We will see that more and more in North America. Ontario has already begun to adopt the government subsidy programs that have made Germany a solar powerhouse.  By investing in solar energy, you are investing in the well-being of the world economy.

One last point about First Solar is that it uses cadmium, a toxic material, in its solar panels.  Although it provides panel recycling services, there will be instances where customers will be negligent.  I can foresee potential problems caused by the use of cadmium.  Having said that, this problem can largely be controlled.  The benefits of the panels offset the toxic materials in a significant way.

First Solar gets a 9 out of 10 for Meaning.

Meaning Score: 9 / 10

Moat Score: 8 / 10
Margin of Safety Score: 7 / 10
Management Score: 8 / 10
Meaning Score: 9 / 10
OVERALL (not an average): 8 / 10

The weakest point in First Solar is in margin of safety.  It needs to sustain a high growth rate for our numbers to be justified.  However, I have put my money on First Solar.  The sustainable energy megatrend will help First Solar realize these growth rates and it is not far fetched to believe that First Solar could become the Exxon Mobil of the future.  If First Solar has meaning for you, definitely use this as a starting point of your research.  Good luck!