Thursday, October 27, 2011

Shorting - early can be wrong: First Solar edition

At Bronte we mostly short frauds. Our typical positions are tiny (less than 1 percent of funds under management). The reason is that if a company has fake 20 million in earnings and a market cap of $200 million there is nothing stopping it having fake $200 million in earnings and a market cap of $1.5 billion. A real company increasing its earnings from $20 million to $200 million is hard - business is tough. A fake company is just a stroke of a pen. You are thus more likely to have a really bad experience shorting frauds than real companies. The only solution we know is to short many frauds and keep the positions tiny and the aggregate position small.

Sometimes though we short real companies. The beauty of a real company in decline is that the earnings are not going to rise sharply and hence the stock is unlikely to go up five fold rapidly. You can safely take a much bigger position. A four percent short position in a real company has about as much capital risk as an 80bps position in a fraud. (It however has a lower expected return.)

At one stage our biggest short (indeed the second biggest we have ever had) was First Solar. It is a much better company than we usually short - and it was the non-fraudulent nature of the accounts that allowed us to take such a large position. There was no way that the stock was doubling because there was no way the earnings were rising sharply.

Alas earnings took some time to fall sharply. And we carried the short for about a year and about broke even. It was not a fun experience because we used capacity (capacity that would have much better been allocated to Chinese frauds!) and because it added to our misery during our worst couple of months ever (in the middle of 2010) as the stock raced up into the 160s. We were not short First Solar for the recent collapse in stock price.

Our analysis was not bad - not entirely accurate - and the inaccuracies are painful when you look at them from 18 months distant - but all-in we were mostly right.

Except we made no money. With a long early is just early. With a short early is plain wrong.

But just to wallow in the misery here are the two key posts reprinted. They were long the first time. They feel interminable now. (Originals can be found here and here.)


John


Post 1: Why I am short First Solar

(The following is an extract from Bronte Capital’s client letter. I thought it deserved wider circulation. It also provides grist to Felix Salmon who described shorting – and in the context by implication me – as socially useless. I think that was harsh – but not necessarily in this case. I will write an article in the future on socially useful short selling.)
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Case study: our short on First Solar

Investing in technology stocks has lots of traps for neophytes – and by-and-large we are neophytes so we do not do very much of it. We however spend a lot of time thinking about it primarily because we are scared of what technology can do to other businesses. (The demise of many low-tech newspapers provides a good demonstration of why – as investors – we should think about technology.)
Technology offers value creation like few other industries. In Australia Cochlear has created enormous value and improved the world. It can literally plug a bionic ear into someone's brain-stem and get them to hear. And the stock has paid about 20X – which is better than anything in our portfolio. Many of the biggest fortunes were made in technology. But technology – and specifically technological obsolescence has thrown many a fine company to the wolves. Palm for instance is likely to go bankrupt even though the concepts it pioneered are in everyone's pocket.
We do however have a framework to hang around our (limited) technology investments. A technology, to be a really great investment, must do two things. It must change part of the world in a useful way – a big part of the world is better of course – but you can be surprisingly profitable in small niches. And it must keep the competition out.
In technology the competition is remorseless. In most businesses the competition might be able to do something as well as you – and it will remove your excess profit. People will build hotels for instance until everyone's returns are inadequate but not until everyone's returns are sharply negative. Even in a glutted market a hotel tends to have a reason to exist – it still provides useful service. And someday the glut will go away so the hotel will retain some value.[1] In most businesses the game is incremental improvement. If you get slightly better you can make some money for a while. If the competition gets slightly better you will make sub-normal returns until you catch up.
In technology the threat is always that someone will do something massively better than you and it will remove your very reason for existence. Andy Grove – one of the most successful technologists of all time (Intel Corporation) – titled his book “Only the paranoid survive”. He meant it.
If your technology is obsolete the end game is failure – often bankruptcy. Palm will fail because Palm no longer has a reason to exist. If we wait 20 years Palm will be even more obsolete – but the hotel glut will probably have abated. Nothing left in Palm is likely to have any substantial value. Businesses that produced plenty now, 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, Google are ones that seem to). Hard drive makers changed the world (they allowed all that data storage which made things like digital photography and internet multi-media possible). But they never made large profits – and they trade at small fractions of sales.
The limited technology investments we have are not driven by any real understanding of the technology. Sure we try – but if 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 is Garmin. We have a small short position in what is a very fine company. Garmin – once a small avionics company - led the mass-marketing of satellite navigation and allowed John – without stress – to find his son's Saturday sports game. Sat-nav it seems has saved many marriages and meant that school sports teams do not run short players because dad got lost.
Garmin has over a billion dollars cash on the balance sheet – and that cash represents past profits. It has changed the world – and thus far it has been well remunerated.
The only problem is that they can't keep the competition out. Nokia has purchased a mapping company. Iphone now has a Tom-Tom app, downloadable for $80 in Australia. Soon sat-nav will be an expected application in every decent mobile phone. Google has mapping technology too and will embed it into their android phone. Eventually the maps will be given away because people might book hotels using their sat-nav device whilst they are travelling. [It is darn useful to know where a decent hotel with a spare room is when you are on the road.]
Garmin has a great product. They have improved my world. The only problem is that 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 being displaced? We don't think so – but then capitalism is not necessarily moral or fair – but it does produce goods and services quite well. We don't invest on the basis of fair – we invest to make you good returns.

The solar industry – and the possible failure of the good

First Solar is a company that improved the world. It drove the cost of production of solar cells to quite low levels and made utility-scale solar farms viable with only modest subsidies. There are some places where solar is now viable without subsidies.[2]

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

Moreover we suspect that First Solar's profits are about the same as the rest of the industry put together. The stock still trades with a high teens trailing price-earnings ratio – a fading growth stock. It hardly looks like a failure. It is a strange conclusion to come to. So we should explain how we got there. To do that we need to explain how a solar cell works.

How a solar cell works

To make a solar cell you need three things.
1). A substance which is 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 electrons away.

Thin film versus wafer

Traditional solar cells were made with a semiconductor ingot cut to a thin sheet. On one side it was “doped” with a substance that kicks out electrons. The other side was laced with wires to conduct the electrons away. This was expensive.
There were generally two types of ingot – monocrystalline – where the wafer structure was perfect or near perfect and polycrystalline which had visible crystals in the wafer. Monocrystalline wafers are primarily used for computer chips (where atomic level imperfections are problematic) and are expensive.
Polycrystalline silicon is cheaper. For most large-scale uses polycrystalline wafers were sufficient. These have about a 17 percent conversion rate – which means that 17 percent of the photon energy that strikes them is turned into electricity.
The ingot itself was a substantial part of the cost of a photovoltaic cell. Polycrystalline ingot used to sell for $450 per kg.
First Solar (and others) developed a process for making solar cells with considerably less semiconductor material. They have a Cadmium Telluride process which vapor-deposits semiconductor at atomic level thickness and comes up with a cell that is now exceeding an 11 percent conversion ratio.
This company is a technological wonder. Glass goes in on one end of the manufacturing process and comes out as solar cells at the other with next to no human intervention. Labour is used only when it comes to putting frames around the glass and for similar tasks.
This was revolutionary – it made cheap solar panels and hence made possible commercial scale plants like this 1.4 megawatt roof installation in Germany. This is enough to supply a few hundred households – not earth shattering – but a complete revolution in the solar industry.
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We can think of few companies which have pushed a technology so far and with such high environmental benefits. Companies like this will allow us to maintain a modern lifestyle whilst addressing greenhouse issues.
Still for all the benefits of First Solar’s cells, they are inferior in many important 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, whilst 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 too so inverters, connectors, installation all cost more with thin film. Thin film also degrades over time. First Solar warrants their performance over their lifetime – but with the warranty being for lower levels of performance in the second decade of operation (google the Staebler-Wronski effect for a non-trivial explanation). Thin film does however have some advantages in low light - keeping a slightly greater proportion of their peak capacity.
Indeed the main advantage of thin film is cost – and that cost advantage has been driven by the cost of the semiconductor component. After all ingot did cost $450 per kg.
That cost advantage made First Solar absurdly profitable – and they used that profit to grow into a behemoth. Revenue has grown from $48 million to over $2 billion. Gross profit (before selling and administrative costs) has grown to over $1 billion. We do not want to 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 all other things being inferior). And that cost advantage is predicated on expensive semiconductor material.

Competition cometh

To make money in technology you need to do two things. Firstly you need to change the world (which First Solar clearly did) and secondly you need to keep the competition out. Alas very few businesses manage the second trick.
The competition came in a couple of forms. Firstly it came from Applied Materials. Applied Materials, or AMAT (as the company is known) is the most important company in the world you have never heard of. It is the dominant maker of capital equipment that goes into semiconductor factories and it is thus the company that – more than any other – provides the kit to keep Moore’s Law active.
AMAT has tried competing head-on with First Solar in the thin-film space. AMAT developed the vapor deposition equipment that made large-screen LCD televisions possible. This entails deposition in large sheets (5.6 square meters) which are then cut down into several large screen TVs. An imperfection in the vapor deposition shows on the TV as a bad pixel.
AMAT appropriated this technology for solar. The silicon semiconductor is not as efficient as First Solar’s Cadmium Telluride technology – and it is equally subject to the Staebler-Wronski effect, however they can do much larger panels than First Solar (with comparably lower wiring, inverter and balance of system costs). AMAT’s thin-film business could do 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 wafer business. AMAT (often the protagonist) has developed wire saws for cutting wafers thinner and thinner. They are now 80 microns thick. These wafers are so thin that they flutter down in air and break if held on their side. AMAT will of course sell the whole kit for handling these wafers – including laser etching material and other steps in the manufacturing process. Much less semiconductor is needed in the wafer business.
But worse – the price of ingot has fallen – and spot prices are now $55 per kg – which is a lot less than $450. The cost of ingot is still falling. First Solar’s advantage is entirely dependent on the fact that they use much less semiconductor than wafers – an advantage that disappears entirely as wafer prices fall. At that point all of First Solar’s many disadvantages will shine through.
We are trying to work out the cost-structures of the polycrystalline manufacturers – but it looks to us that the extra glass and other balance of system costs that First Solar panels have are getting close now to completely removing the advantage of low semiconductor material usage.
If that happens though, First Solar is toast. It probably won’t file bankruptcy because it has so much in past profits to fall back on – but it will be every bit as obsolete as a Palm organizer is now or a Garmin car navigation system might be in five years.
We do not wish failure on First Solar – and if we are right 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. We make money from getting the business analysis right and betting on (or against) the right business – and in this case we are betting against the most successful company in a massively important growth industry.
If we are right (and we think we are) then we will make money from the demise of a company that has much improved the world. We like to think our business is noble. And it is sometimes – but in this case we can see why people dislike short-sellers. Their opinion however is not our business.

[1] Unfortunately the hotel is usually mortgaged – and the 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 Southern United States. They did this originally because of implicit subsidies. However the test centers showed something quite interesting. Good solar panels turn quite a lot of the energy hitting the rooftop into electricity which is conducted away. That energy does not wind up as heat in the building – and the cooling load of the building went down. The rooftop solar installation may not have been justified by the electricity output alone – but combined with lower cooling bills it worked a treat. [Addendum. This footnote is anecdotal from good source rather than published... many people have asked us about it - and a few have said they have heard this sort of thing before but they would like hard data... I apologize as I am unable to provide...]

Post 2: Kickback on First Solar

One of the biggest benefits I get from writing this blog is that sometimes some very smart people disagree with me. In the investing business you will be wrong often. The earlier you realize that you are wrong the smaller (on average) your losses will be. I don’t think the blog can move markets through talking my book. (I disclosed a good argument for shorting First Solar and the stock went up!) But I do think that kick-back from smart people can help reduce my losses when I am wrong. Believe me that is often enough! If all that the blog delivers me is smart people who disagree with me then I will wind up being a well-paid blogger (and my clients will be grateful)!
I got a lot of kick-back on my First Solar piece – some of which makes me more nervous about the short – and some of the kick-back is from people who are very smart. I thought I ought to lay this kick-back out at least in part to get my own thoughts straight.
One of the solar industry trade publications asked my permission to republish the piece – which I have granted. They also warned that they might have a follow-up piece titled: “Why I am short Bronte Capital”. That ought to put us in our place! I have yet to see that piece – but honestly I look forward to it (even though reading it will be painful). It may convince me that I am wrong – in which case I will cover my short forthwith!
The basis for the kickback I have received
The core to my argument was that First Solar has disadvantages (notably lower conversion efficiency) offset by a couple of advantages – notably keeping higher generation in low light, less sensitivity to angle of light – and most importantly – lower cost.
My view was that lower cost would determine almost everything. Solar modules are fundamentally a commodity – and whilst the low-light advantages were real – they could easily be overwhelmed by cost.
I then made an assertion – which I did not back – that the cost structure of wafer-based cells will be competitive against CdTe (First Solar) cells when the polysilicon price gets low enough.
Most – but not all – of the kick-back I have received is based around this cost structure issue. This falls into two camps. Firstly they assert that I have the cost structures of the competitors wrong. Secondly they asset that First Solar will reduce costs enough to offset the advantage that wafer-module-manufacturers get from lower silicon prices.
The other kick-back I have received is on the sales-and-marketing department. First Solar has – according to customers – by far the best sales force. “They are a machine!” First Solar they think that this will allow First Solar to travel well for longer than I might anticipate. Moreover they thought First Solar’s average selling price would remain high because FSLR has presold a lot of modules to solvent utility scale operators – notably EDF in France.
In this post I examine these issues with the aim of getting my own thoughts straight (and hopefully invoking more kick-back from more people that are smarter than me).
A cost model for polysilicon producers
Polysilicon has several disadvantages vis CdTe technology. First the materials are more expensive (wafers are thicker than thin film) – but just as importantly the manufacturing process is much more complicated. At First Solar glass goes into the plant and comes out – about three hours later – as an almost complete module. Human involvement is minimal. Wafers however require more manufacturing – they are sawn – they have breakage rates – they are laced with wires to conduct the electricity away – and they are “assembled”. Manufacturing cost are higher.
That said we can construct a simple cost model for wafer manufacturing from comments made by competitors. YingLi – a Chinese module maker – made the following comment in their fourth quarter conference call:
In the fourth quarter, our non-polysilicon costs including depreciation further decreased to $0.76 per watt from $0.81 per watt in the third quarter and $0.86 per watt in the second quarter and $0.90 per watt in the first quarter of 2009. This decrease demonstrates our strong R&D capabilities, and execution capabilities to continuously improve the yield rate, field conversion efficiency rate and operational efficiency.
The blended cost of polysilicon continuously decreased by the mid-teens in the fourth quarter. I would like to emphasize again that Yingli has now provided long-term (inaudible) provisions to write-down inventory costs or polysilicon prepayments the challenging fourth quarter of 2008.
Now YingLi is a good (meaning low cost) Chinese producer. It has terrible blended costs – but that is because it purchased silicon at high prices and its blended silicon costs are too high. But these costs do not seem wrong relative to competitors. [Inventory problems are surprisingly common in the industry as people hoarded polysilicon to avoid excessively high spot prices and wound up with huge inventories as the price collapsed.] The thing that is most notable about this is how fast the non-silicon costs have been falling – the sequence by quarter is 90c, 86c, 81c, 76c. This is roughly 4c per watt per quarter. It is of course impossible to know how far this will continue to fall – diminishing returns to technology and manufacturing reports will eventually occur. But for the moment we can take 76c and falling fairly fast (roughly 4c per quarter) as the non-silicon costs for various manufacturers. [Contra: slide 8 in Suntech’s latest quarterly presentation gives a much lower non-silicon price. That slide is so “out-there” different I tend to dismiss it – though if anyone has a clear explanation I would like it.]
Solar wafers used to require 7 grams of silicon per watt. Some manufacturers run at about 6.2 grams of silicon per watt – with 180 micron silicon. Applied Materials talk about 80 micron thick silicon wafers – though silicon use for those wafers is not reduced by 80/140 because wire saw (kern) losses are similar regardless of wafer thickness. Also as wafers get thinner they have higher breakage rates (and the incentive to cut wafers thinner is lower as silicon prices fall).
Its probably fair enough to use 6.5 grams of silicon per watt as the right number for modeling a silicon wafer module producer. The 6.5 grams is falling and in five years it may be 5 grams (if AMAT manages to sell more of their kit). Ok – but at 6.5g (or 0.0065 kg) per watt then the cost structure is easy to model…
YingLi cost per watt (in cents) = 76 (less any efficiency they get from manufacturing improvements) plus silicon price (in cents per kg) * 0.0065.
Now I am going to take a wild stab at what the number will be by June 30. My guess is that spot silicon will be $40 per kg and the 76c will be reduced to say 71 cents (which is still falling but by less than the 4c per quarter which the cost has fallen). This gives a cost per watt by the middle of this year of 97 cents. Polysilicon costs go below the magic dollar per watt!
Obviously this is highly dependent on the silicon price – a $20 silicon price would make the cost 13c per watt cheaper – say 84 cents per watt. A $100 silicon price takes cost per watt to $1.41.
Cost is also dependent on YingLi (and presumably the other commodity panel makers) getting efficiencies in the production of modules although at a reasonable clip – though as noted, I model a rate below the historic rate of cost improvement.
[I should observe here that Trina Solar – another Chinese manufacturer – gives their non-silicon costs at 78c per watt – 2c more expensive than YingLi in the fourth quarter. Trina’s cost reductions are also about 4c per quarter… See page 8 of their quarterly presentation.]
This cost model is fraught. The accounting of many of the Chinese players is difficult to decipher. One person I have talked to suggests that most other players are way above 78c per watt in non-silicon costs (although competition will get them there or force them out of business replaced by people who are at that level). They thought YingLi would be at 70c by the end of 2010. Against this the same person thought my grams per watt was too high (suggesting 6 grams per watt based on 180 micron thick wafers) and they thought that YingLi would be at 5.5 grams per watt by the end of the year. This is more or less a wash – with wafer costs a little lower than my estimate but base costs winding up a bit higher. Again all of this stuff is fraught – and although these broad numbers are not controversial the end competitiveness of First Solar is surprisingly sensitive to fine differences in base cost and silicon costs of their competitors.
What is the cost structure of First Solar?
First Solar has laid out ambitious plans to increase the efficiency of their cells and to further reduce costs. I do not want to go through those in detail – but I think we can extract two key charts from the last presentation. First slide 13 – which has the cost per watt falling still – but at decreasing rates. The cost-per-watt has fallen by 1-2 cents per quarter for the last couple of quarters (versus 3-5 cents for the non-silicon costs at YingLi).
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Then there is the less-specific presentation from their “roadmap” (see slide 14) which shows their 2014 target cost per watt.
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I wish I understood how all of these gains were likely to be achieved – but they think they can get to 52-63 cents per watt by the end of 2014. However – for the moment I assume that they can meet their cost target and get to 58c per watt (a reasonable midpoint) by the end of 2014.
That cost per watt reduction is 26c over 16 quarters – or 1.625 cents per quarter – roughly the rate at which costs have been falling historically.
Figuring that the were at 84c per watt during the fourth quarter of 2009 – and they are reducing costs by 2c per watt per quarter (that is a little faster than historic and slightly faster than their roadmap) costs will be about 80c per watt per quarter by the June quarter of this year.
A raw cost comparison – with the price of silicon being the main variable
With the trusty spreadsheet I can produce a reasonable cost-per-watt comparison…
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On this cost structure the YingLi panels have higher production costs unless the silicon price is very low. That sort of makes sense. YingLi panels have higher production costs (the process for making them is more complicated) offset by lower non-silicon materials costs (they are more efficient and hence use less glass, backing wire etc). The swing factor is silicon.
This table however leaves off the single most important swing factor – which is that the YingLi panels are smaller per watt of output. (Remember my whole argument is dependent on the higher conversion efficiency of the polysilicon wafer modules.) There are wildly different versions of how much the installation cost advantage is. The advantage comes about because you need less cells, less land, less brackets and less converters to generate the same amount of energy.
This paper from the National Renewable Energy Laboratory has been my guide. This paper suggests that First Solar modules need to be priced 25-30 cents below c-Si modules to generate equivalent project returns (see page 26). Some people think this far too high. For instance Stephen Simko (an analyst from Morningstar who disagrees with me) thinks a 10 percent penalty (roughly 7c per watt) will do the trick. I for the life of me do not understand why this is a percentage (there is limited evidence that installation costs are falling at the same rate as manufacturing costs). 7 cents per watt is very different from 25-30 cents.
I would really like people to detail what the cost difference is. (If informed people send me emails I will be grateful…) I suspect it depends on all sorts of things like labor costs, brackets, land availability and things you would not expect like wind levels (wind requiring better anchoring for the panels).
For the moment I use 15c per watt (a number my research indicates is too low – but which Stephen Simko thinks is too high). At this point my cost table needs to be adjusted…
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Now at this point the First Solar cells are about cost-competitive at a $40 silicon price. If silicon prices go as low as $20 per kg then the Chinese polysilicon makers (represented by YingLi) have the goods by a long margin.
I should note that this cost structure does not match the cost structure as presented by several people bullish First Solar… Here is a cost structure as presented by Stephen Simko comparing First Solar to Trina Solar (yet another Chinese wafer-module maker). In it however he keeps the silicon price constant at $45.
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You can see the difference between Simko’s estimates and mine. I have Q2’10 costs for the wafer manufacturer a few pennies (say 3c) lower than Simko. Simko has the cost structure of First Solar falling about 3c per quarter (versus my 1.5 cents per quarter and adding up to a further 3c cost advantage) and he has an efficiency penalty of about 8c versus my 15c (or another 7c of cost advantage). He thus has First Solar maintaining a cost advantage of about 15-18c per watt over the next twelve months whereas the extra costs I suggest wipe most of that advantage.
At a $20 silicon price even with Simko’s cost estimates First Solar’s cost advantage disappears. This of course led Stephen Simko and me to a discussion of what drives polysilicon ingot prices. In that he changed my mind somewhat…
What drives the polysilicon price?
Polysilicon is a commodity. Sure there is better quality stuff (which makes more efficient wafers) but it is still a commodity. Usually with a commodity – when there is spare capacity in the system – the commodity is priced at the cash running costs of the highest price operational plant. When the world runs out of capacity the commodity disconnects from its “cost curve” and is priced at whatever the market can bear. At that point being a commodity maker is frightfully profitable. That profit attracts new entrants and new capacity. Eventually there is enough supply and the commodity price reconnects to the cost curve. (This pattern is familiar to anyone who has – for instance – studied metal prices generally. The pattern drives much of the Australian economy.)
As the solar industry ramped up polysilicon prices disconnected from their cost curves. Spot prices of $450 were not unknown. The NREL paper cited above mentions spot prices higher than that. The spot price however was rarely paid – because most wafer makers purchased large inventories and entered into forward contracts. Some solar-cell makers have got themselves knotted up financially because they have purchased thousands of tons of polysilicon inventory at prices that are well above current prices and which prohibit them from making profits.
The excessive profits made by the ingot makers introduced many new suppliers to the industry. One source suggested that we have gone from six suppliers (and a cozy oligopoly) to 26 suppliers (who will cut each other’s throats). This market is becoming very glutted very fast. That means that the poly price will go to marginal cash cost. So what is that cost?
Well I started with the big players – and they have cash costs in the low 20s. I thought the polysilicon price would thus go to the low 20s. That would settle the issue because – even on the Stephen Simko’s numbers – the Chinese-wafer-based modules will have lower costs than First Solar at a $20 polysilicon price.
So – without stating it so clearly – I thought that the poly price would wind up closer to $20 per kg than the $45-55 modeled by most First Solar bulls.
Stephen Simko disabused me of this notion – and this time I am fairly convinced by his explanation. During the boom the most insane polysilicon manufactures built plants and with very different cash costs to the established (and presumably knowledgeable) players. He thinks the cash cost outside the established players is considerably higher than the cash costs of the established players. He points to a presentation by REC Silicon. Slide 45 of the presentation gives what REC purports is an industry cash-cost curve and whilst the Y-axis is not labeled the bottom of the curve represents about $20 a kg – and the top of the curve represents – well – who knows what? Here is the slide:
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If this curve is correct the polysilicon price is unlikely to get to $20 because the marginal players will have costs substantially higher than $20.
The issue comes down to how flat is the cost curve? It strikes me – intuitively – as being likely to be very flat as the equipment to make silicon is pretty well understood – but if anyone is genuinely expert in this then I would love them to contact me. [The cost curve REC/Simko showed me however is emphatically not flat…]
This REC graph however has given me pause – because the really brutal outcomes for First Solar were dependent on a very low silicon price. If the silicon price were really to go to $20 and my cost numbers (somewhat more brutal than Simko and other bulls) are right then First Solar will wind up with no reason to exist – and the stock will go below $10 (currently about $130). If the poly price does not go below $45 and Simko’s numbers are right then First Solar will keep a cost advantage – and that cost advantage is sustainable – at least until a better technology comes along or First Solar’s patents run out. First Solar earnings might be difficult – but the business has a reason to exist.
Funny – I have not mentioned profitability
So far – in neither of my notes – I have not made a profit estimate for First Solar or any of the competitors. I have modeled cost – but thus far have not modeled selling price. Once we have a reasonable estimate of selling price and a reasonable estimate of cost we should be able to model profits give or take some things. [The main things we would need to give-or-take are inventory losses for the silicon manufacturers – some of whom have thousands of tons of overpriced silicon inventory, and the project gains and losses for First Solar which is an investor in utility scale solar projects.]
Looking at the current price for modules is not going to help you much. Many companies have both purchased silicon at fixed rates and pre-sold panels at fixed rates. First Solar locked in lots of fixed rate contracts – some with good solvent parties (for example EDF) – some with parties that are more questionable. The current prices realized by the solar manufacturers depend more on the contracts that they entered into (both price and solvency of the counterparty) and less on spot price for panels than a first glance might look.
There are disclosures in First Solar’s 10K which illustrate the problem. These disclosures can be read as “red flags” though I prefer to keep more neutral about their content.
During the first quarter of 2009, we amended our Long-Term Supply Contracts with certain customers to further reduce the sales price per watt under these contracts in 2009 and 2010 in exchange for increases in the volume of solar modules to be delivered under the contracts. We also extended the payment terms for certain customers under these contracts from net 10 days to net 45 days to increase liquidity in our sales channel and to reflect longer module shipment times from our manufacturing plants in Malaysia. During the third quarter of 2009, we amended our Long-Term Supply Contracts with certain of our customers to implement a program which extends a price rebate to certain of these customers for solar modules purchased from us and installed in Germany. The intent of this program is to enable our customers to successfully compete in our core segments in Germany. The rebate program applies a specified rebate rate to solar modules sold for solar power projects in Germany at the beginning of each quarter for the upcoming quarter. The rebate program is subject to periodic review and we adjust the rebate rate quarterly upward or downward as appropriate. The rebate period commenced during the third quarter of 2009 and terminates at the end of the fourth quarter of 2010. Customers need to meet certain requirements in order to be eligible for and benefit from this program.
Essentially the customers or sales channel was liquidity constrained – so terms needed to be made more generous (45 days versus 10 days). Moreover we needed to offer a price rebate (presumably a rebate on our fixed price contract) to enable customers to compete. Those rebates were subject to certain tests (presumably solvency tests but we do not know the content of those tests). Some of these contract changes exchanged smaller fixed price contracts for higher volumes at lower fixed prices.
Whatever – the industry is rife with fixed price contracts. Spot prices are below the fixed price contracts. One day these fixed price contracts will roll off – and new fixed price contracts will struck at considerably lower prices. As we do not know the duration of the fixed price contracts – and even if we did that duration keeps getting extended in exchange for lower prices – we can’t really tell the path of the selling price.
But I have a method which should be familiar to any economist – and I think works for working out where the long term selling price will wind up. It is simple really. The Chinese competitors are numerous and very hard to pick apart from each other. Some are ultimately going to be pennies per watt better than others – but because they are numerous and in fierce competition they will drive the price. This should be bleatingly obvious – anyone who has competed with numerous Chinese manufacturers by now would know that the price is driven down to the price where the Chinese manufacturers make a mid single-digit ROE.
That price however is much lower than the current selling price and probably much lower than the selling price First Solar will realize in 2010.
Moreover the price should be fairly easy to determine: I will just do it for one manufacturer. At year end Trina Solar had book value of $677 million. Some of that value was inflated because they were carrying some high-cost silicon inventory. They had output ability of about 550 megawatts per year (averaging 600 in panels and 500 in wafers). To earn 15 percent pre tax on that equity they need to make roughly 100 million per annum or they need a margin of 18c per watt sold. The first-cut estimate of the long term price of these things is thus – and I am being very simplistic here – whatever the Chinese manufacturers cost plus 18c per watt.
This first cut however is a sharp over-estimate. The equity I am including is too high because of overpriced inventory. The ROE I am demanding is too high too (Chinese competitive manufacturers make far less than that!) The industry is continuing to get efficiencies – and they will be competed away – so the margin per watt will come down for that reason too. You do not need to make any unreasonable assumptions for the right margin per watt over the cost for the Chinese manufacturers to be 10c.
From here an earnings model is easy… First Solar will produce (on their guidance) about 1.7 gigawatts this year and 2 gigawatts next year. The selling price will be whatever YingLi’s cost is plus 10c… You can work out the margins using either mine or a bull’s cost estimates (I use mine). Multiply margin by wattage and you get pre-tax profit – give or take a little bit. I do this below.
image
Now – using numbers I think are inherently likely – I get earnings falling sharply. If we take the silicon price to $20 then First Solar has no earnings. If we think the installation penalty is 25c rather than 15c as per the NREL paper earnings go away up to a silicon price of about $40.
Now Mr Simko reckons that the cost advantage of First Solar is about 13 cents per watt better than my number. [He has an 8c installation cost rather than my 15 etc…] 13c per watt equates to $20 per kg on the silicon price (remember we are assuming 6.5 grams of silicon per watt). In other words if you use Simko’s numbers then take my silicon price estimate and add $20 (say $60 instead of $40) to read the earnings numbers. Even on Mr Simko’s numbers First Solar’s earnings fall fairly sharply when the competition amongst Chinese manufacturers drives their ROE down to normal Chinese levels. That makes me more comfortable with my short. First Solar may not be a devastating failure but earnings will fall sharply and the stock starts with a teens PE ratio…
Innovation and the long-term future of First Solar
So far my argument has been predicated on the silicon price falling. At low silicon prices First Solar becomes uncompetitive. The only real question being how low is low?
But First Solar can become more or less competitive depending on how much they can reduce costs or increase efficiency versus their Chinese wafer-based competitors. First Solar has an ambitious target of reducing costs over the next four years. I want to repeat the slide on that cost reduction strategy.
image
Now I know you have seen this slide before… what you probably did not notice is that it is not drawn to scale. The company plans to get 18-25 percent cost-per-watt reduction via efficiency – and and only 15 or so percent cost-per-watt reduction through everything else (plant utilization, scale etc). That makes sense because First Solar plants are already highly automated. Glass goes in one end and almost-complete modules come out the other end with little human intervention. It is almost impossible to improve that manufacturing because it is already almost perfect!
So the only place they can get their cost-per-watt down is by getting more watts-per-glass-sheet – that is improving efficiency. Efficiency is the core to First Solar’s roadmap to lower costs.
I will be blunt. I do not think they can do it. Efficiency is already 11.1 percent. If they get 21 percent out of efficiency – something like a midpoint of their 18-25 – then they need to get efficiency to 13.4 percent – and they need to do it over 16 quarters. Efficiency must improve almost 15 bps per quarter. Efficiency for the last six quarters was 10.7, 10.8, 10.9, 10.9, 11.0, 11.1 percent – something less than 10bps improvement per quarter. This is something which should asymptotically approach a theoretical limit – and yet First Solar is modeling that the rate at which they improve efficiency will increase for the next four years. Maybe they can do it – but trees do not grow to the sky.
Against this – what is driving the Chinese manufacturers is manufacturing efficiency as well as conversion efficiency. The Chinese processes are difficult – involving sawing, lacing wires on wafers and assembly. There are many more and difficult steps than First Solar’s thin film process. That is bad for them now but provides opportunity. Chinese manufacturers are – if we know anything about them – relentless in taking out costs.
So my guess is cost-per-watt will fall faster in the Chinese silicon manufacturers than in First Solar precisely because there are more opportunities for manufacturing improvement.
Stephen Simko had the opposite view. He figured that thin film is a new technology whereas wafers have been around for a long time. That means that there are more opportunities for conversion efficiency improvement in thin film than wafers – and he thought that would drive costs over time. I have an answer to that – 10.7, 10.8, 10.9, 10.9, 11.0, 11.1. But really to get comfortable with that I want to talk with a particle physicist who knows a lot about semiconductors. My knowledge of (low energy) particle physics (and hence the mechanism by which a thin film semiconductor might work) is not much more than you can garner from Brian Cox’s excellent mass market book on Einstein and the Standard Model and a few other populist things (many from Mr Cox). On the interaction between atomic sized gates and the efficiency at which electrons can be forced across a thin-film semiconductor layer I am – as you might expect – totally out of my depth…
So there you have it – the whole First Solar thing modeled out. I think I am right – but sensible people take the opposite view – and one industry publication wants to write a piece about why they are short Bronte Capital. If anyone tells you this investing game is easy ignore them. This is tough – and the bets we take occasionally fill us with angst.
John

22 comments:

Anonymous said...

I am shorting FSLR through some Dec 2011 put since $82. The situation seems to be quite different now than 2010 when you first wrote your post. Price of the solar panel is being driven down by too much supply and sudden drop in demand. PVinsight reported that Polysillicon solar panel module are sold about 1.08 per watt average and thin film is selling at 0.85 per watt average. I would imagine at this rate FSLR will be lossing money after factoring in the overhead cost.. What is your take on the China manufacturers? Will they do the rational things and slow down product when the price is lower than they cash cost? Or will they continue to produce panel at max pace becuase of the supplier contract?

Anonymous said...

There is no guarantee that a company in decline does not BECOME a fraud. In fact, I submit that the risk of fraud is an increasing function as a company declines from winner to loser.
Did you already bake that into your 4% vs. 80bp?

John Hempton said...

I should do a post on "fraud from inception" versus "fraud from decline".

Your fraud from decline problem is real. It makes some things in decline much poorer shorts than they should be (riskier shorts really).

John

Anonymous said...

Hi John,

are you shorting any of the digital camera makers?

imagine if Apple had stuck to the ipods and didn't transition to iphones and ipads---the ipod business line has become a profitable but declining business for Apple.

as i see it, as soon as some idiot crack the problem of squeezing a cost-effective bigger sensor into a phone, the digital point-and-shoot camera market is effectively dead.

Anonymous said...

Whats your take on the earnings statement that came out today for fslr. It doesnt appear even close to as doom and gloom as youd expect given the decline in stock price and some of the things you pointed out in your post coming to fruition (ever declinining polysilicon prices).

My personal take is at least in the very short term the chinese manufacturers look to be in much much worse shape than fslr as many were selling at a loss last quarter and prices have continued a steep decline as far as i can tell.

iwannabrich said...

HEY JOHN,
BEEN REALLY ENJOYING YOUR BLOG SINCE THE LAST COUPLE OF MONTHS(STARTED MY OWN RECENTLY AFTER 'discovering " FROM UR BLOG THAT EVEN FORTHRIGHT HONESTY CAN GIVE YOU INTERESTING STUFF TO WRITE ABOUT,IM AN ENGLISH HONORS STUDENT SO I HOPE U UNDERSTAND THAT IM SURROUNDED BY "CLASSICS"..... BUT THATS ANOTHER STORY).READING YOUR BLOG IS LIKE READING THE AUSTRAILIAN VERSION OF TALEB...YOU BOTH HAVE AN INCREDIBLY WEIRD "COCKTAIL" OF HUMILITY,INTELLECTUAL FLEXIBILITY AND ARROGANCE(YEAH YEAH I KNOW OXYMORON...HELLO IM A 19 YEAR OLD ENG.MAJOR!!!) THAT MOST PEOPLE FIND INCREDIBLY ANNOYING BUT IMHO IS UNFORTUNATELY A VERY USEFUL QUALITY TO GET CLOSER TO THE TRUTH.WHAT I FIND MOST REFRESHING ABOUT YOUR BLOG IS THAT UNLIKE MOST VALUE INVESTORS(YES U R 1 , GRAHAM WROTE ABOUT YOUR KIND AND WOULD HAVE WRITTEN MORE IF DERIVATIVES HAD EXISTED IN HIS DAY...HENCE NO USE DENYING IT...LOL!!!!!!) YOU ARE NOT JUST A GLORIFIED "JUNK YARD GUY"(THAT IS NO NET-NETS AND JUST AVERAGE COMPANIES SELLING AT BELOW AVERAGE PRICES 4 U IT SEEMS ...ATLEAST SO FAR AS IVE RAED ...A DISTINCTION WHICH I FEEL NO SHAME IN APPLYING TO MYSELF...TO MODIFY THE BREAKING BENJAMIN SONG LYRICS...IM NOT A LOVER / HATER,IM A LIQUIDATOR...ROFL!).KEEP UP THE GOOD WORK,HOPE TO CATCH U IN OZ AND INVEST WID U SUMDAY.
HAPPY DIWALI
AND A HANDSHAKE ACROSS THE MILES
YOURS GREEDILY,
IWANNABRICH
P.S WHENZ THE FRAUD IN DECLINE VS FRAUD BY BIRTH POST COMING UP?
AND YEAH FRAUD POSTS ARE THE MOST FREAKING AWSUM PART OF MY DAY
TC.

Anonymous said...

John,

"fraud by decline" would be an interesting topic, but I figure "timing the downfall" might be just as good, and probably more challenging to yourself, seeing how some of your recent posts admit to several "correct shorts but way too early".

Regards,
Dmitry

Anonymous said...

John

I would very interested in a post on "timing shorts", to echo previous comment.

J

evwarsh said...

Someone has to say it because we're all thinking it...an English major? Really? You sure?

revelo said...

I didn't see your sell price, but the date of the first post was 4Apr2010. FSLR closed at $121.30 on 1Apr2010, and $46.11 on 26Oct2011, for a profit of $75. Let's be very conservative and say you locked up $160 in capital (the price in Feb of this year) the whole time. $75 profit on $160 capital over 19 months is over 27%/year on an annualized basis, which isn't bad. So why do you say being early is the same as being wrong? Furthermore, 19 months is NOT a long time to wait for an investment to pay off.

Anonymous said...

evwarsh:

I hope, for the sake of our future, that this guy is a troll. If people like this are going to be voting in politicians, we're all screwed.

John Hempton said...

I think he might be an English major in a country where English is a second language.

A bit like me being a Japanese major.

I tend to weed out trolls when I put the comments up - but in this case I had a fair guess he was not.

John

Anonymous said...

John,

I think you were wrong when you shorted this stock. The problem in the solar industry is more or less correlated to the Europe crisis. So you were not early but wrong.

Anonymous said...

Troll or not, Jeff Matthews wouldn't publish that, and neither should you.

Anonymous said...

Re efficiency: Are you sure that 18-25% efficiency number is entirely based on panel operating efficiency?

They could be referring to a combination of panel operating efficiency and manufacturing efficiency. Do we know what the QC failure rate for panels is? If most of that 18% is going to come from better manufacturing processes it may not be so unfeasible.


Re digital cameras: quality has for some time been largely limited by lens quality, not sensor quality. While phones have gotten better, they will never match the quality of even a cheap discrete camera until they also have the (heavy) lens assembly in the camera.

The question then is what proportion of camera sales are to people who would be willing to forsake quality in their happy snaps for the convenience of a phone. I can see people doing this for birthdays etc, but when someone goes on their overseas holidays, they're still going to want to have a real camera.

Especially in the last 2 years there seems to have been a big expansion in the low end SLR and prosumer (eg Canon PowerShot G) segments. I certainly wouldn't be so quick do dismiss Canon or Nikon right now.

Anonymous said...

I think you were wrong when you shorted this stock. The problem in the solar industry is more or less correlated to the Europe crisis. So you were not early but wrong.

Tell us why John is wrong? I thought his thesis is right on. Polysillicon spot price already drop to $30/kg. We will start seeing the financial impact in 4Q11 and 1Q12. Price of Poly solar panel dropped to around 1.08/watt and thin file is about 0.78/watt. Europe crisis force the solar panel demand to slow down and create a glut of product but it does not change the competitive dynamic between different technologies.

Anonymous said...

Whats your take on the earnings statement that came out today for fslr. It doesnt appear even close to as doom and gloom as youd expect given the decline in stock price and some of the things you pointed out in your post coming to fruition (ever declinining polysilicon prices).

We will see what is holding up the earning when FSLR release their full earning next Q. My guess is taht they sold a couple of DOE guarantee project on 9/30 and there are one time gain and most of the panel are sold with contract in place and the spot price has not fully impact the bottom line yet.. It will probably take a couple Q (at least) before we see the full impact of the price change to FSLR bottom line. If you subtract the full year guidance from the first 3Q, you will notice a very big range for 4Q ($1.7x to 2.7x range).. We are already 1 months into 4Q, why do you think the range is so high? My guess is that there may be a volume issue of how many panels they can sell in 4Q.

iwannabrich said...

Dearest readers of Bronte capital,

im under the impression that the readers of this blog represent a demographic of the population with above average IQ's as well as a real desire for making money through exploiting market inefficiencies. Mr.Hemptons blog serves as an impressive forum for curious free spirited minds for uniting for discussion as well as mutual desire for analyzing and evaluating investment opportunities TOGETHER, minds which i believe tend to focus on uncovering the truth and not caring for the form in which it is presented.

I can assure you to the best of my knowledge that im 100% human(although a deeply flawed one) and not a 'troll' , although i sometimes truly wish i was one(especially if you mean the fairytale or world of warcraft version which can smash stuff into pulp).I have a very real tendency to make VERY poor choices on a daily basis and hence have made more mistakes on a daily basis than most of you in your entire lifetimes. One of these poor decisions involved a 1 year stint in law school out of which i ve recently dropped out ( LOOOOONG STORY), which has led me to my present situation(the great thing about this course, is however that i get a lot of time to learn the family biz and focus on my real passion-learning to exploit market inefficiences).What i most remember about that suffocating ,cut throat and "unreal" environment is that these so called seekers of truth a.k.a 'academics' were deeply affected by an intellectual disease called confirmation bias(a disease which unfortunately has to be faced by me on an almost daily basis) which caused them to shield their egos by issuing "ad bonheim "insults and make disparaging personal remarks especially when they really didnt have anything real to say about the issue at hand.
Now please don’t take this the wrong way , im not accusing anybody of this, you guys are a bunch of bright, ambitious and pretty street smart guys , ESPECIALLY those of you who can understand Mr.Hemptons incredibly well researched and impressive blog posts at the first go( a duffer like myself has to go through them atleast 2-3 times to get the whole point and still end up learning new stuff each time),BUT IT SEEMS EARILY REMINISCENT.

Im unaware as to how shoddy english writing skills/a sincere admiration of Mr.Hemptons work (which i believe is all anybody here knows about me) is in anyway a hindrance in electing any real leader to office.i tend to view elections as short term popularity contests where what somebody promises and actually accomplishes in office is being affected by more variables than what an average joe has a clue about MOST of the times.If anybody has any rational(and if possible empirically proven) ideas on how to elect better people to office PLEASE let me know(my election card is going to come up in a few months and i would love knowing that im voting for somebody even a little better than the current bunch of dishonorable rotten "douchebags" who are in the Indian parliament).i sincerely view you people collectively as a bunch of independent ,thoughtful and opportunistic people capable of striking at the

iwannabrich said...

'jugular vein' of "capital relocation opportunities" who are not afraid to stand alone while the world(i.e investment bankers,analysts,hot shot traders etc ) mock them as long as they are convinced they are right.

As far as jeff Mathews is concerned (i.e. if you are referring to the im not making this up blog guy who wrote the secrets in plain sight guy), comparing bronte capital to it is like comparing Godfather to Goodfellas , totally different dude!

Hope this will not be misconstrued as false modesty or worse insincere flattery , but the’ legend’ of Mr.Hemptons showdown with that cowardly financial advisor is what gives me courage on a daily basis to confront my demons(especially the ones called sloth and its distant cousinthe fear of sticking your neck out).
Maybe someday ill be able to become hyper rational like you all and learn to take constructive criticism in my stride instead of fantasizing about becoming a troll and smashing things to pieces times infinity.

Yours troll loving wannabe investor,
Iwannabrich

p.s Trust I ve hurt nobody’s feelings , if I have im profoundly sorry. times infinity.

Yours troll loving wannabe investor,
Iwannabrich

p.s Trust I ve hurt nobody’s feelings , if I have it is regretted.

Ronald Brak said...

The repost mentions that installing solar panels on a roof can result in significant savings in air conditioning costs. This is definitely a real effect, although the largest saving in air conditioning costs comes from the panels shading the roof rather the conversion of sunlight to electricity. Plain white panels without solar cells would actually have a greater cooling effect. Of course, at todays prices it wouldn't make sense not to use solar panels.

Anonymous said...

@iwannabe rich
http://www.americanselect.org/

Anonymous said...

I will make a comment about solar panels reducing the need for air conditioning as a qualified maybe. This is probably a fairly complicated function of the emissivity of the front and rear surfaces of the panel and of the roof, and of the thermal transmission through the panel. (Emissivity is a material property that describes the ability to absorb and relect energy. Shiny aluminum has low emissivity and is a poor absorber/good reflector, while asphalt has high emissivity and is a good absorber/poor reflector. Emissivity varies depending on the type of energy - infared, visible, or ultraviolet.) The solar panel must absorb some fraction of the incident energy and convert it to electricity, while the remaining energy is either reflected or warms up the panel. A panel should be able to be hot on the top and cool on the bottom, keeping the roof cooler than normal, but there is no requirement that is actually the way they are built.
Rich

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The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author.  In particular this blog is not directed for investment purposes at US Persons.