Rule #1 Analysis Blitz #8: Google (GOOG)

For this post, I'm going back to a stock I own.  It's probably a stock you know too, especially since you're reading this on the internet.  From a brief look at the statistics of this blog, about 90% of traffic is directed here from this search engine.  Yep, you guessed it, it's Google (as if you didn't know from the title of this post)!

Relatively speaking, Google is a really young company.  It was founded only in 1998 and became a public company a little more than 6 years ago.  If you are over 30 years old, you probably remember there was a time before Google was around.  When you wanted to search for something on the web, you would open your Netscape browser and click on the "Search" button.  It then brings you to some search page, of which, frankly, I can't recall the contents.  Later on, I realized that there were actually websites that did these searches.  My early favourite was Alta Vista.  Then, some time during my university days, I switched to Google.  I can't remember exactly when that happened, but it did so very naturally and I never looked back.

The same thing happened with Mapquest.  From Mapquest, I went to Yahoo maps just because I had a Yahoo account.  But when Google maps came on the scene, it was a no-brainer.  I didn't have to click on the arrows on the map to move north/south/east/west.  Just click the mouse and drag the map around...it was so intuitive and convenient.

Moving my main email account to Gmail took a little longer.  As you may know, I have my own domain and have been using POP3 email through Outlook to access my email.  Then, the frequency at which I checked email became less and less, because it was a hassle to download email (along with all the spam) onto my computer.  As well, I couldn't access my email while on the go. I had (still have) a Yahoo email account, but it was just never quick enough.  Then, I took the leap and let Google host my email account.  I get to keep the felixwong.ca address and have the convenience of having my email in the cloud.  Gmail is also amazing fast and keeps your emails in its appropriate threads.  Spam hardly ever gets into my inbox either.

I'm not going to go through all of my transitional stories to Google, but I think you get the point.  Its products and services are really top notch and I believe Google's management are real visionaries.  Let's see if the stock is "investable"!

Moat

You can download the completed Rule #1 spreadsheet here.

Before we begin, note that Google has only gone public for 6 years.  So, any data before that was from its private days.  I wouldn't pay attention to much to it's 9-year numbers, not that they're bad or even mediocre!  Everything looks astounding!  With the exception of sales growth, the lowest growth number in the summary table was last year's BVPS and it was at 26.4%!  Sales growth last year was relatively slower at 8.5%.  It raises a yellow flag, but with a 8.5%, it's close enough to our 10% threshold to give it a pass, especially since 2009 was just the beginning of the economic recovery.  We also see zero debt; in fact, Google has amassed $33 billion in cash.  There are only about 250 companies worldwide that have market caps as large as this amount!  Without a doubt, Google has one of the best balance sheets amongst the mega-cap companies.

Google makes a significant amount of its revenue from advertising.  They are the ads that appear at the top and right of the search results page that are under the "Ads" title.  The average advertiser pays about $0.50 - $2.00 every time a link is clicked.  When I was still in school, I never really understood why anyone would click on those ads and how Google could make any money.  However, when I started working and wanted to search for vendors, I found those ads to be very useful, sometimes more helpful than the search results themselves.  The reason is that I was trying to find somebody selling something, but the search results gave me everything from news on the topic, to a blog post, to a definition on wikipedia, etc.  The ads gave results only of people trying to sell stuff.  That's exactly what I was looking for, and because the ads are contextual (based on the keywords that I typed), they are usually pretty good.  The second major part of Google's revenue comes from their Adsense ads, which you can find on this blog after a post and on the right column.  Google scans the page for its content and matches advertisements that fit within that context.  As you can see on the ads on this blog, the advertisers are usually stock brokers or financial companies.

So, the moat of Google has to do largely with its search engine.  Why would you want to stay with Google?  Actually, let me ask myself why I would stay with Google and not go with Microsoft's (Ticker: MSFT) Bing? I did switch from Alta Vista to Google fairly painlessly.  If you have used Bing, there's definitely some appeal to the product.  It looks nice and the search results aren't bad either.  But why haven't I switched yet?  It's because Google offers a host of other products that have increasingly built up my loyalty for the company.  Many people criticize Google for offering products that don't generate cash, but I say those services are the essential ingredients to building an awesome brand moat.  When I switched from Alta Vista to Google, it was just a matter of changing my bookmark on my browser.  If I wanted to switch from Google to Bing, there would be this invisible mental blockade that prevents me from doing so.  I would unconsciously say to myself, "Ok, you use Gmail, Google Maps, Google Reader, Blogger, Android, why not just stick with the search engine?"  And that's exactly what has happened.  Although Google may not even give the most relevant results (I wouldn't know since I don't even use Bing or Yahoo), there's a preconception (perhaps even misconception) that Google is just better.  That is brand moat!  It's just like people choosing Coca Cola over Pepsi even though time after time, Pepsi does better in blind taste tests.

And Google was kind enough to give me a personalized "Happy Birthday" doodle for my 32nd birthday yesterday!  Why wouldn't I stick with Google?

As Google continues to branch out even more (just do a search on Chrome OS, Google TV, Google eBooks), it will get more and more intertwined with various aspects of your life.  If any company is going to produce a Skynet (from Terminator 2) or the Matrix, it's going to be Google!

Having said all this, it is not unimaginable that another company, Microsoft (although I doubt this would happen) or another startup, may displace Google in what it does.  The cost of switching over is not terribly great either.  You may need to fiddle with things for a couple of days, but after that, your internet presence can be switched over to any other provider.  So, Google does not get a perfect 10 for moat...it gets a 9!

Moat Score: 9 / 10

Figure 1: Rule #1 Analysis of Google (GOOG)

Margin of Safety

The sticker price on Google is $844.53 and entry price is correspondingly $422.26.  The stock is trading at $601.  So, the stock is still underpriced, but not enough to justify starting a new position right now.  This is using the assumption that future growth is at 20.4% and P/E ratio will be 21.6.  If we use a slightly higher growth rate of 23.5% and the current P/E ratio of 24, then the entry price would be $605.  I'm not going to use these assumptions, though, because I want to be more on the conservative side.  

Do keep in mind that it has about $104/share in cash.  If we could just "eliminate" that from the share price, it'd be at $601 - 104 = $497 and we can pretend that Google has no cash right now.  That's actually a pretty attractive price.  But there is some risk to this type of discounting method.  So, tread carefully.

Payback time is 8.8 years, which is pretty good, but this does hinge on a 20.4% EPS growth rate.

Google gets a 7 for Margin of Safety.  I would have given it a 6, but due to its strong cash holdings, I gave it a bonus point!

Margin of Safety Score: 7 / 10

Management

Google management gets a fair bit of spotlight, partly because it's the biggest internet company, but also partly because it sometimes come up with the wildest ideas, and any one of them could be game changers (or busts).  Sergei Brin and Larry Page were the Stanford graduates who created Google.  Due to their inexperience in actually running a business, they hired Eric Schmidt, then CEO of Novell to be Google's CEO.  Schmidt had been the CTO at Sun Microsystems before that.  Some call them the Google Triumvirate.  While Schmidt generally runs the business, it's Brin and Page who mainly drive the company's innovations.

Without a doubt, Schmidt is a seasoned veteran in the tech space.  Brin and Page, together, essentially eliminated all other search engines at the time with their mispelled website, Google (was intended to be Googol or the number 10¹⁰⁰).  These 3 dudes added together bring the brightest minds of Silicon Valley into one place, and that's definitely nothing to scoff at.

Similary to Apple's (Ticker: AAPL) CEO Steve Jobs, the Triumvirate each get paid a total of $1 each year.  Wow, I feel like a millionaire when I compare my pay to theirs!  Of course you know that's not what their total compensation is!  We would be able to see in Google's annual report what kind of compensation they are getting, but I'm not going to dive into that detail.  They probably have stock options, etc.  However, I do like that their pay is a symbolic $1. It means that their interest is in line with shareholder interest.  Since their compensation is stock based, whatever happens to their stock happens to their fortune.  As of January 2010, Brin and Page together owned about 57.7 million Class B shares of the company, which would be worth about $34.7 billion dollars right now!  That's not even counting what Schmidt owns (I believe he owns about $4 billion worth of shares).  The duo planned to sell 10 million shares over 5 years to diversify their holdings, but I'm not really worried about that.  With more than $30 billion at stake, the Triumvirate has more interest in growing shareholder value over the long term than any other shareholder!

I don't know if any other company has a more talented management team.  Schmidt is the seasoned veteran (distinguished in his own right), flanked by two brilliant, young, enthusiastic founder.  If Google doesn't get a 10 for management, I don't know what company does!

Management Score: 10 / 10

Meaning

From my introductory paragraphs, you can likely tell I'm a huge Google fan.  I use its search engine, Blogger, Reader, Maps, Gmail, Android, Analytics, Youtube, Apps, etc.  I know more about this company than most other.  The only disadvantage is that I may be biased towards it in my analysis.  I hope this is not the case here.

Anyway, as I mentioned long ago, I had some concern over Google's political leanings, especially of its support for legalization of same-sex marriage and rights of same-sex couples.  However, I did find some consolation when I looked at the USCCB investing policies that support of same sex marriage was not listed explicitly as something that would turn away the USCCB's investment funds.  Having said that, the USCCB still advises against investing in companies that "protect human life" and "protect human dignity".  I believe the support of homosexuality falls somewhere in these 2 categories.  I won't go into it too much, but I'm sure somewhere somehow, supporting same-sex marriages runs counter to the Catholic faith, but luckily not to the extent that one cannot invest in such company in USCCB's opinion.

On the brighter side, because of its left leanings, Google is also a very good corporate citizen.  Google has a philanthropic arm, Google.org, which has a number of initiatives to improve the well being of humanity.  Google has also invested a large amount of money in renewable energy.  It probably has its hands in the following USCCB categories: Pursuing Economic Justice, Protecting the Environment, and Encouraging Corporate Responsibility.  As many know, Google has an unofficial motto, "Don't be evil", and I believe many of its initiatives do offset, if that could even be done, its support for same-sex unions.

Just this year, Google decided that it wasn't going to continue censoring its results on its Google.cn website.  This is a bold endorsement for a freer China, but the Chinese government was quick in its response and began to block Google's site.  Google now puts up a link on its Google.cn website to its Hong Kong website, Google.com.hk, where the Chinese government plays by different rules.  This is somewhat of a workaround, but it shows that Google is not afraid to stand up for what it thinks is the right cause.

Another piece of news that surfaced this year was that Google collected wifi information as it was collecting Streetview images for its maps.  I actually don't think that was unethical, because it was only collecting information that was freely accessible and not encrypted.  So, Google was able to see information that people were sending back and forth on unsecured networks.  In my opinion, if you're on an unsecured network, you have to assume that your data is going to be visible by others.  In any case, Google apologized for this action and promised not to use those data collected.  Be your own judge on this issue.

With a company having the size and success of Google, there's always fear of it monopolizing its markets.  As Google continues to grow, its competitors will allege that Google is violating anti-trust laws.  Whether they be true or not, you should keep your eyes open to discern whether Google is doing anything unethical.

I will give Google a 7 out of 10 for Meaning.

Meaning Score: 7 / 10

Summary

Moat Score: 9 / 10

Margin of Safety Score: 7 / 10

Management Score: 10 / 10

Meaning Score: 7 / 10

OVERALL (not an average): 8 / 10

Although a mega-cap in its own right, Google is still a growth stock.  The internet is still in its infancy stage.  50 years from now, we will look back at what we have today and think how far we have come.  It would be like looking at a Ferrari Enzo today and then comparing it to the original Ford Model T.  Google is in the best position to capitalize on this (r)evolution.  Cloud computing will be the next stage of the game and we will see how it eventually pans out, but I would put my money on Google.  The company is like an octopus with its tentacles reaching into different spaces.

You may want to wait for a pullback before buying your first shares, but as the stock is still undervalued (just not 50% off), it may not see too much of one, especially since the macroeconomic conditions have improved. Lucky for me, I got in early.  I'm going to enjoy this ride!

The Catholic Investor is Getting Some Notice!

I've got some pretty cool news!  Just a few days ago when I published my post on Netflix, Google Finance decided to put a link to the post on its NFLX page (see image above).  I got about 100 hits from this link in one day.  I thought it was pretty awesome and wanted to share this with you.  That's it!  See you!

Rule #1 Analysis Blitz #7: Netflix (NFLX)

Just a couple of months ago, Netflix, the online movie rental sevice, became available in Canada.  Netflix had been around in the US for many years (founded in 1997).  Its initial service was DVD rental by mail.  How it worked was as a subscriber, you pay a monthly subscription fee and choose a number of movies you wanted to see in your queue.  Netflix would then ship you a DVD in your queue for viewing with no late or penalty fees.  You get to keep the DVD as long as you want and when you're done with it, Netflix would ship you the next DVD in the queue.  Depending on your subscription plan, you can get one DVD at a time or multiple DVDs at a time, and different number of DVDs per month.  Of course, if you wanted to make your subscription fee go far, you'd return your finished DVD (by a prepaid mailer) as quickly as possible, in order to get the next DVD.  This business model has been fairly successful as there has been some copycats.  In Canada, the most prominent one is Zip.ca, of which I considered joining, until Netflix came along.

Why did I go with Netflix?  Their current movie selection in Canada is actually very, very limited, but I started my 1-month free trial offer anyway, because they offered streaming to PCs and my PS3.  So, I can watch movies anywhere I want as long as I had access to a PC and an internet connection.  That sealed the deal for me.  In the US, Netflix has begun to roll out a streaming only plan for subscribers.  The movie selection in the States is superior to that of Canada.  I was willing to bite the bullet and spend $7.99/month just to have the convenience of streaming videos.  To date, I've watched about 20 movies since I started my trial in October.  That's less than $1/movie...granted, I could've probably borrowed the same movies from the library for free, but the convenience justifies the nominal fee.  I can't wait for Netflix to improve their selection.  At that point, it'd be a no-brainer for anyone to subscribe to it.

In light of this, Netflix has become a very hot stock!  In one year, the stock has risen from about $50 to $184.  Can this fantastic growth continue?  Let's find out!

Moat

You can download the completed Rule #1 spreadsheet here.

Going to the Big 5s, the ROIC, Sales Growth, and Free Cash Flow Growth all look pretty good.  The EPS growth also looks good.  The 9-year average has a negative number but only because it had a negative number in the beginning years.  The BVPS actually raises a red flag.  We will ignore the 9-year average since it had a negative BVPS in its first years.  However, even the 5-year average number and 1-year number do not pass the 10% threshold.  You'll see the details of the BVPS in Figure 2.  The BVPS started declining 2 years ago and then took a big jump downwards last year.  I dug a little deeper and found that Netflix took out $200 million worth of debt last year, which was the culprit bringing down the BVPS.  Having debt is not a big issue, as long as the free cash flow is sufficiently large to be able to pay it off relatively quickly (i.e. in 3 years by Rule #1 standards).

In Figure 1, you will see that it takes Netflix 2.8 years to pay off its current debt using the free cash flow from last year.  We'll call this a pass.  It's ok for a company to carry debt, just as it is ok for you to have a mortgage.  However, it's much preferred if the company can finance its growth with earnings and not debt.  What this shows is that the operating margin of Netflix is probably not that good.  Otherwise, money would be pouring in and it would not need to borrow cash to grow its business.  A quick check at Yahoo Finance shows a 12.85% operating margin.  Although there's no hard and fast rule how much this should be, I personally like it to be at least 20% to show that the business has a true moat (i.e. they can charge the customer a high price for their product).  For comparison sake, Apple (Ticker: AAPL) has an operating margin of 28%, Google (Ticker: GOOG) 36%, Coach (Ticker: COH) 32%.

Netflix currently has little competition in the streaming arena.  The company that comes closest is Hulu.com.  However, the content is considerably different.  Hulu focuses on TV shows and has a very limited selection of movies (even worse than that of Netflix Canada).  Apple TV and Amazon also has streaming content but are on a pay-per-view basis, although their content is better.  Youtube may become Netflix's biggest threat; Google recently announced that it was planning to offer free premium content from the biggest studios.  On the DVD rental front, Blockbuster is going down (in bankruptcy protection).  Redbox is the only real competitor at $1/rental/night.  But my guess is Netflix will eventually go all streaming and drop its DVD rentals.  All-in-all, I think Netflix has a pretty good position going forward.  As we noted, its operating margins are pretty thin and if any competitor figures out a good assault on Netflix, it could be in trouble.

Netflix gets a 7 out of 10 from me for Moat.

Moat Score: 7 / 10

Figure 1: Rule #1 Analysis of Netflix (NFLX)

Figure 2: BVPS History of Netflix (NFLX)

Margin of Safety

Netflix is currently trading with a P/E ratio of about 70!  This is like the P/E ratios of the dot-com days.  What's even crazier is that it's P/B (Price-to-book) ratio is 50!  I can tell you Ben Graham would never buy Netflix if he were still around.  Perhaps the growth justifies this valuation, who knows?  Let's take a look.  I used the analysts' estimated growth rate of 26.3% (high in itself) and also a historical P/E of 21.7.  Yes, the P/E is 70 right now, but I don't believe this can be sustained for more than a year or two.  Remember, we're thinking long term here (e.g. 5 to 10 years or more!).  The sticker price comes out to $142.93, which means the entry price is half of that at $71.47.  Netflix is currently overpriced at $185.  However, if you're willing to risk it and dial up the P/E ratio assumption to 56, then Netflix is right at entry price now.

This section is all about margin of safety.  With a P/E ratio of 56, you have little room for error.  You want to be conservative in your estimates and have a margin of safety.  When you have both, you really have a good margin of safety!  Therefore, I would rate Netflix as a risky investment right now.  It gets a 4 out of 10 for MOS.

Margin of Safety Score: 4 / 10

Management

Reed Hastings is the CEO of Netflix.  He is the founder of the company and also sits on Microsoft's (Ticker: MSFT) board.  He is quite the visionary for revolutionizing the way people rent movies, and possibly be the cause of Blockbuster's demise.  Hastings is definitely a smart guy.  There's no doubt about that.

You can also see his intelligence from his trades.  In the past 12 months, he has sold $40 million worth of Netflix stock!  He still has about 1.2 million indirect shares, which is worth about $220 million now.  As you can see, as the stock rose to lofty levels, he slowly offloaded his shares, locking in some gains.  He knows that the valuation of the stock at P/E ratio of 70 is probably a little high.  With 1.2 million shares still at stake, I believe Hastings has a good reason to run the company well.  His recent sale does not show disloyalty to the company, but rather, Hastings' prudent management of his finances.

I give Hastings an 8 out of 10 for his Management.

Management Score: 8 / 10

Meaning

Streaming video is great!  I love the convenience of it.  The only reason why I would end my Netflix subscription would be my lack of time for watching TV.  If my work day wasn't 6:30 - 6:30 (including commute time) and I didn't have a young daughter at home, and doing a part time Master's program, Netflix would be a no-brainer.  Even still, I'm planning to keep the subscription for the foreseeable future.

Are there any red flags with Netflix in terms of ethics?  Probably.  Let's dissect the business a little bit.  Netflix  rents movies to viewers.  What could go wrong there?  That was a rhetorical question!  If you're thinking R-rated movies, you've hit the nail on the head.  There are quite a number of questionable movies on Netflix, especially with some of the more sexually explicit and/or violent films.  Of course, there's no X-rated movies on Netflix, but some of the R-rated stuff are still pretty unnerving.  Although the USCCB's investment policy is not to invest in companies whose significant portions of revenues derive from X-rated films, this is still a somewhat problematic area.

Aside from this, there wasn't much dirt to dig up with Netflix.  They get a 7 out of 10 for Meaning.

Meaning Score: 7 / 10

Summary

Moat Score: 7 / 10

Margin of Safety Score: 4 / 10

Management Score: 8 / 10

Meaning Score: 7 / 10

OVERALL (not an average): 5 / 10

If Netflix were below my entry price of $71, I'd probably consider buying it.  However, at $184, the price is a little steep.  I'm not saying the stock won't continue its upward trajectory in the near term, but if it misses a quarter, there might be quite a bit of pain!  If it were to drop down to a P/E ratio of 45 (still a high value), the stock would be at $118.  Ouch!  Not my cup of tea.  I'd much rather buy a company with a P/E of 10 when it should be at 20!  Do keep your eyes on this company...if its price falls significantly, you may want to add it to your holdings.

Merry Christmas!

On behalf of my family, I wish you a joyful and peaceful Christmas.  As the year winds down, I hope you can find the time to reflect on how gracious the Lord has been to you this year.  I know I've got a ton of things I need to be thankful for...including you!  I want to thank all of you for reading my posts.  If you haven't already, please consider subscribing to my feed (click here  Subscribe in a reader).

Again, have a wonderful Christmas!  May the Lord shower you and your family with His many graces in the new year!

USCCB Socially Responsible Investment Guidelines - Part 2: Protecting Human Life

First Ultrasound of My Daughter, Adele (9 weeks)

The first of the 6 areas covered by the investment policies of the USCCB is "Protecting Human Life".  Needless to say, human life is precious, and as investors, we must ensure that our investments go towards companies that protect human life.  Sometimes it is difficult to find a business that directly promotes the protection of life, but at the very least, they should not contribute to the destruction of human life!

The 3 sub-categories under this area are:

1. Abortion
2. Contraceptives
3. Embryonic Stem Cell / Human Cloning

Abortion

There are many people who do not believe abortion is morally wrong.  This blog is not the place to argue against that notion.  I will assume that you agree with me that abortion is gravely evil.  The USCCB uses an absolute exclusion approach (i.e. does not invest in these companies at all) towards investing in companies that have direct participation in or support of abortion.  Direction participation "may include, but not be limited to, companies involved in the manufacture of abortifacients and publicly held health-care companies that perform abortions when not absolutely required by federal or state law."

Anytime you are interested in a pharmaceutical company or a health-care provider, you should look into whether they participate in the above.  Many large pharmaceuticals manufacture abortifacients (drugs that induce abortions).  They include Johnson & Johnson, Pfizer, Teva, Watson, etc.

Contraceptives

Contraceptives include any artificial means of preventing pregnancy from occurring.  They may include condoms, oral contraceptives, vasectomies, sterilization, skin patches, diaphragms, etc.  As you can see, this category is much broader than abortifacients.  You can bet there are many more companies involved with manufacturing contraceptives.

The USCCB will not invest in companies that manufacture these products, and more importantly, even those who generate significant revenue from sales of these products (even if they don't manufacture them).  So, think drug stores like Rite Aid and CVS in the US and Shoppers Drug Mart and Pharma Plus in Canada.  Sales of condoms and other contraceptives probably don't amount to a large portion of these drug stores' revenues, but do keep in mind they are selling these products.  There are probably thousands of other companies which are not, in any way, connected to production or sales of contraceptives.  So why go there in the first place?

Embryonic Stem Cell / Human Cloning

Embryonic stem cell and human cloning are no longer the stuff of science fiction.  They are very real and we must be vigilant in our investing choices.  I would also put in-vitro fertilization under this category as well.  Companies that take part in these activities do not respect the dignity of human life.  They treat human embryos as objects for manipulation.  Companies like Geron and BioTransplant engage in embryonic stem cell research.  Anytime you're looking at biotech companies, make sure they are free of these activities.

Conclusion

As I have said before, I try to avoid all pharmaceutical and biotech companies because it is almost impossible to fully figure out whether all of their products and services do not violate the dignity of human life.  It does eliminate a large number of potential companies, but the USCCB did not put the human life category first for no reason.  They probably believe that this is the area of greatest concern, and I would tend to agree.  If we do not respect human life itself, how are we to expected to behave morally in other circumstances?  Protecting human life should be the first thing that comes to mind when evaluating a company's worthiness!

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.

Moat

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

Management

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

Meaning

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

Summary

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!