Friday, April 30, 2010

First Solar – a follow-up post the result

Such is the life of a short-seller.  The biggest short in our fund (First Solar) came out last night (Australian time) and – again to use the Australian vernacular – hit us around the head with a bit of 4 by 2. 

It was ugly.  The stock was up almost 18 percent and was the best performed stock in the S&P.  Moreover it has been up for a few days prior to the result.  This has not been a profitable position.

On the plus side we run a portfolio – and somewhat unbelievably the customers performed about with market despite this blow.  Obviously Bank of America – our biggest long – was up 5 percent – and that position is more than double the size of our First Solar short.  Also – and less obviously – our next biggest short (which I will refrain from naming) was down hard.  Those two more than offset First Solar and the rest of the portfolio was merely OK.  [Even the Spanish bank short – also a largish position – did not hurt us despite Santander’s blowout results.] 

If you just looked at the aggregate you would not even notice the “First Solar Pain” – but I don’t look at the aggregate – and I am hurting – if only via wounded pride.  So it is time to have a re-examination – a look at what went wrong or did not go wrong.  After all I need to know whether to persist in this loss-making position.  As I introduced you (dear reader) to my initial thoughts I will introduce you to my continuing thoughts.

When to persist with a loss making short

There are three reasons for covering a short – and only one of them is a happy reason. 

The first reason is that the thesis has played out and you have made your profit. 

The second reason is that your thesis is wrong.  At Bronte Capital we have a strict “no broken thesis” rule.*

The third reason for covering a short – one that happens all-too-often – is that the short poses too much risk and must be reduced for risk control.  This happens with shorts but not longs because when a long goes against you (that is down) it gets smaller and hence does not threaten the fund.  When a short goes against you (up) it gets larger and hence often must be reduced for risk control reasons.  This is the main practical difference between shorting and traditional long investing.  Positions on which you are wrong shorting hurt a lot because they get larger and you wind up wrong on larger positions.  (Leveraged long investing – which we do not do – requires risk management similar to shorting.) 

Anyway – there are only two reasons I will cover the First Solar short after this beating.  One is risk control – and that is more-or-less automatic.  If the position is too large we will trim it.  The other is that our thesis is wrong.

I am not going to tell you about the risk control process (unless you want to become a client).  I will tell you about the thesis.

Our thesis – and the the First Solar results

Our thesis for First Solar – run through in detail in the two earlier posts [here and here] has a few parts.

Part A - is that crystal silicon modules (c-Si) are becoming cheaper to manufacture because the Chinese are getting good at producing them and that the most expensive ingredient (polysilicon ingot) is becoming substantially cheaper as the market has become competitive and glutted.

Part B – is that the Chinese c-Si producers are competitive and that over time the price of modules will come – through normal competitive pressure – down to near the cost of c-Si cells – that is costs will determine prices.

Part C – is that the lower price of c-Si modules will compress First Solar’s margins (First Solar uses a thin-film CdTe technology) and competes almost entirely with c-Si manufacturers.  Moreover First Solar will not be able to reduce its costs because it is so efficient already – essentially that FSLR’s “roadmap” to lower costs is nonsense.

Bluntly – it is Part B above that I am wrong on.  The price of modules received by FSLR was very good and margins remained fat (and indeed got fatter).  In the original thesis Part B was the bit without a time-frame – and I might be right or might be wrong on it in the long run – but I am most certainly wrong on the basis of the last quarter.

Lets deal with the bits I am right on so far -

Part A:  There is no doubt that c-Si cells are becoming cheaper to produce.  First Solar said “the low end of guidance has resilience to $40/kg poly and c-Si processing cost of 75c/watt by Q4 for non captive demand”.  (See p23 of the results presentation.) 

I am going to come back to that sentence because I think it is central to what has happened – but for the moment note that these are assumptions about competitor costs that were unthinkable only 18 months ago. 

The cheapest of the competitors (say YingLi) will be below 75c/watt by Q4 – but it is unlikely the average Chinese manufacturer can get to that target.  As for the poly price I think it will be below $40/kg – but it is not there yet.  That said – it is obvious that they need to deal with competitors with much lower cost structures than previously.  The first part of my thesis is not broken

Part C: The company has an aggressive plan (“the roadmap”) for reducing their costs per watt by the end of 2014.  This plan was illustrated in the following (not to scale) picture:



Note – the vast bulk of the cost-saving (18-25 percent) was to come from “efficiency”.  Well the conversion efficiency of the cells remained unchanged at 11.1 percent (see p.28 of the results presentation).  They need – as my last post explained – to improve the conversion efficiency by approximately 15bps per quarter over four years to meet their target.  They are behind schedule.

The company states its cost per watt each quarter.  Usually they cite “core costs” (that is not including “stock compensation” and “ramp up penalty”).  Those costs were stable at 80c/watt.  This quarter they cited “total costs” in the conference call as those dropped 3c/watt to 81c/watt. 

They can’t meet their targets by dropping non-core costs to zero – they have to improve their core costs – and the main way that they plan to do that is via increasing conversion efficiency – and they are not on target.  The third part of my thesis is thus not broken.

The problem part of my thesis

The problem part of my thesis is pricing.  And boy is that broken. 

In the fourth quarter of 2009 – a quarter that disappointed – First Solar had operating profit of roughly 145 million and production of 311 MW.  Some of the profit is for their development business – but – at a first approximation it is reasonable to think of this as operating profit of 47c/watt.

In the first quarter they had operating profit of 191 million and (nicely increased) production of 322 MW.  This is – at a first cut – operating profit of 59c/watt. 

Now operating costs per watt only changed 3c/watt (and all of that was “non core”).  Operating profit changed 12c/watt.  The company shot-the-lights out on price received.

Unless there is something peculiar about First Solar this will probably apply to every solar producer – including the marginal Chinese.  But whatever – competition has not driven down prices at least yet

Competition and prices

It is a core part of my world view that competition tends to squeeze margins – but it has not happened here.  There are short-term reasons that are easily identified.  The most obvious is that Germany has a concessionary feed-in-tariff regime which will be adjusted (down) from the end of June.  There is massive demand in Germany for panels to be installed by the end of the second quarter.  First Solar is sold out

That sort of demand pressure (sudden, urgent) is enough to delay what (I hope) is the inevitable reduction of prices to reflect lower Chinese costs. 

However whilst it is part of my world-view that competition tends to squeeze margins it is not universal.  Some things just don’t have much competition – I never notice margin squeeze at Microsoft.  Also some things that are ostensibly competitive (beverages) seem to maintain fat margins for very long times (for example Coca Cola).   I don’t see any particular reason why the third part of my thesis won’t be right eventually but I am open to persuasion otherwise. 

The prices received

I said I would get back to the mathematics of the guidance – in particular the comment that: the low end of guidance has resilience to $40/kg poly and c-Si processing cost of 75c/watt by Q4 for non captive demand.

Now c-Si cells use about 6.5 grams of poly per watt (a number that is reducing).  This means that the guidance is resilient until the c-Si makers have costs of (75c plus 0.0065*40c)/watt = $1.01 per watt.

Now c-Si cells should (and do) sell for more per watt than other cells (such as amorphous silicon) because c-Si cells are cheaper to install due their higher efficiency.   I thought that difference should be about 15c/watt – but I have seen numbers as low as 9c/watt and as high as 30c/watt.  The usually accepted number is about 25c/watt – but – to make the case as favorable to FSLR as possible I will chose a low (10c/watt) penalty. 

If we get to prices being set by C-Si costs at $1.01/watt (plus say 8c/watt profit for the Chinese producers) then we should get to 99c/watt (including profit) for FSLR.  FSLR’s costs are at 80c (core costs) and for the moment look pinned.  This implies margin at FSLR at 18c.  This could be higher if FSLR reduces costs – but is unlikely to be dramatically higher.

FSLR’s margin in the first quarter was 59c/watt.  Bluntly – if the Chinese get to the costs on which the FSLR’s guidance is based then FSLR’s profit crashes if FSLR has to match the Chinese prices

It would be hard to see how FSLR can maintain its guidance under these conditions.  Except that FSLR gives us an out – they say that they are resilient “for the non-captive demand”.  FSLR can maintain higher selling prices because it has “captive demand”.

FSLR has captive demand because it is also a project developer and it purchased another project developer (Next Light Renewable Power) very recently. 

The question is – is it sustainable to be selling to internal or captive power developers at prices substantially above Chinese costs?  Obviously it is in the short term because the solar panel market is “sold out”.  It is not so obvious in the long term.

In the long term either (a) the prices at which First Solar sells to “captive demand” has to match the Chinese prices or (b) First Solar is investing its balance sheet in high cost (and hence uncompetitive) captive projects. 

Obviously this can continue for a while – whilst prices remain high for solar panels.  But I think it will end – and FSLR’s earnings will crash when it ends.  I think Part B of my thesis is only temporarily wrong.  So I will (subject to risk management) keep my position. 

The market of course has a different view – and that difference is painful.  Having a short go up almost 20 percent on a result is – to put it mildly – unpleasant. 






*The no-broken thesis rule was detailed in David Einhorn’s book on Allied Capital.  Its funny but in a book about a more-than-average difficult short the thing I most benefited on was some (very) wise words on portfolio management.   


Steve said...

I think you're too tied to the idea that your thesis is right or wrong. There are a lot of other considerations that go into a trade.

Risk/Reward- I can't believe you're still in this position. As far as I can tell, you entered around 120.00. That means it's 25%against you now. That strikes me as a LOT of running room. I mean, do you expect to cover FSLR at zero?

I don't base my trades on charts, but I will look at a chart to put a trade in context. FSLR is a heavily traded stock by the momentum crowd. They could run this thing WAY up with only the slightest excuse for a catalyst.

I don't particularly like this grand thesis idea for a trade. You've got too much ego/emotion tied up in this trade. This is the usual pitfall for people who like to short in that they believe they're smarter than the crowd. I used to be that way but have learned the painful lesson. And of course as Keynes said, "markets can stay...blah blah."

As I mentioned in a previous post, you are exposed to crude on this trade as well. Hopefully you have some hedge for it. Ideally, a FSLR short might make for a good pair trade... long some other solar stock.

I'm sorry that I haven't articulated myself well, but I think this trade is wrong on so many levels. Cover on a pull back.

John Hempton said...

Actually Steve - I do expect to cover the FSLR closer to $10 than you think. I think the case against it very strong indeed. But I admit that the prices received for solar panels are startling me on the upside.


hedgehorn said...

First Solar's excess profits (and the industry's) are currently being driven by government stupidity, namely that of Germany. This is not a free market where competition is correctly functioning. The German government has been slow to drop the FiT, even as module costs have dropped significantly. There is anecdotal evidence that 4GW has already been installed in Germany this year. This suggests not just a pull forward in demand, but a developer gold rush into German solar development because of balooning IRRs.

It is shocking that this is allowed to happen in one of the worst countries for annual sunlight. I personally believe the German government will eventually have to face the problem because the subsidies will pressure the budget or spur revolt among the people who are seeing their utility bills skyrocket.

What scares me is that even if Germany rights their ship, there are plenty of other countries where government is totally clueless. Ontario, Canada, where First Solar has a decent pipeline of projects, is just one example. It is a northern locale, making solar even more expensive, yet they are subsidizing solar. For now, these other markets (including the US) are not large enough to offset German demand if it craters. First Solar can tout PPAs on 500MW US utility projects all it wants, but it is not clear that many (or ANY) projects of this size can ultimately be completed in the US. It is notable that the largest PV development in the world to date is around 60MW. Even if First Solar can get massive utility projects off the ground, they still have to compete with other project developers and other sources of electricity. Unless utilities and governments in the US are really that stupid, I can't imagine First Solar earning these same returns in the US that they are earning in Germany today.

Lastly, what gives a short some additional comfort is that First Solar and the Chinese c-Si producers all continue to add capacity (FSLR announced yet another 220MW). If governments wise up, demand will fall enough to send PV prices to shockingly low levels very quickly.

Christian said...

Just in case you were not aware of this:

The EU directive on the Restriction of Hazardous Substances has been proposed to be applied to all electrical and electronic equipment, instead of just household equipment. Those hazardous substances containing equipment would include CdTe panels.

The various lobby groups appear to battle over this one. I'm not sure what the end effect will be. I doubt it's actually going to be a ban, but I think this bears watching.

As a start, here's a link to a story on the topic.

Andrew said...

#2 short must be GMCR given your past forays into k-cups (DDRX and PEET).

Anonymous said...

On the demand side, solar is almost wholly driven by government subsidies. In a world of increasing deficits and bondholder enforced government austerity, this cannot continue.

When Spain/other EU countries decide to cut the green subsidies since they can't afford to pay bondholders, this bubble will pop. Until then, you're relying on a much more complicated (abeit probably correct) competitor/margin analysis.

C. Fuzzbang said...

Thanks for posting this. We are all wrong and wrong often in this business. But it's not often you see someone publicly turn it into an education session.

Russell said...

As solar displaces fossil fuels California government policy is to keep prices high in order to encourage energy efficiency. The utilities will actually earn more money and further government policy by buying more expensive panels.

David said...

I have to agree with Steve. First, I would think that you would have some fairly tight stops on a short - say 7 percent. Second, looking at the chart, FSLR broke out of a two year down trend about three weeks ago - not something you would typically want to go against. AND oil is going to trend up because of several situations (increased spending, drilling platforms blowing up, etc.), a positive for FSLR. So . . . have to say that while you have good reason to short, it is just a bad time to do so. You might do better shorting the market right now. QID would be a good position - added to my portfolio yesterday. Thanks for always good thoughts and writing.

Abhishek said...

You can add these 3 factors to your short thesis.

1) Operating Expenses - The Opex Margin for First Solar at near 20% of revs is twice that for comparable Chinese companies. It had do with cost of its American management which is 10 times more costly than Chinese and $90-100mm in Stock Compensation.

2) Inflexibility in adding capacity - First Solar takes more than a year to add capacity compared to less than 1 quarter for c-Si guys. That means they can't take advantage of huge demand in 2010 with high volumes which their competitors can. They have zero capacity additions in 2010

3) Costs - I would expect with 4% added throughput their costs would come down but they have'nt

I agree with you that Long Term First Solar has a case for underperforming the solar market.But the solar industry demand is rocking due to price elasticity so you may be wrong in shorting the sector . The 50% decline in module costs is being truly reflected in 2010 with easing of the crisis.One way out would be to long the industry winners

Anonymous said...

One thing that strikes me about FSLR is they make a commodity product largely differentiated on price alone (although they have a slightly better mousetrap for now), and their enterprise value is $11.7 billion, yet their cumulative capex to date is about $1.3 billion. In other words, the market values the company at 9x what it cost to build the company in the first place.

No commodity manufacturing industry that I know of has ever sustained an EV to replacement cost valuation of greater than 1x - cement, nitrogen fertilizer, petroleum refining, etc. And, it's a lot harder to get plants permitted in those industries than in solar panel manufacturing. Barriers to entry in the solar business are minimal.

If somebody gave you $11.7 billion could you take FSLR down? I think the answer is obviously yes.

In the last year almost to the day, Form 4 insiders have sold $800 million worth of stock. That's nearly 7% of the current market cap.

狂猪 said...

Hi John,

Even assuming your thesis is correct, can you elaborate a bit more on why you feel FSLR should be closer to $10? It's current P/E is only 19 and it has a clean balance sheet.

David Merkel said...

You have made the appropriate analysis that being short is the opposite of being leveraged long. Few get that. Kudos.

John Hempton said...

If my thesis is correct the company will wind up as the HIGH COST producer facing a bunch of Chinese competition.

If that is the case then it has no reason to exist at all... the plant is useless and they will have invested most the clean balance sheet and taken a few losses on the way.

That is $10 stock stuff.


Steve said...

On a positive note for your short, FSLR has a mighty P/S ratio; 6.2.

Also, looking at a weekly chart, it's making a MASSIVE descending triangle with the base around 100.

In the event that it breaks under that 100'ish support area, I'd add to the short aggressively.

If you were interested in putting on a long hedge, SOLR is a good value play.

All the best,

狂猪 said...

Hi John,

I disagree with your $10 fslr estimate. Here is how I would calculate it. I know the following butchers probability a bit and it takes some coarse shortcuts. It is only a rough estimate.

First, let's assume your thesis is correct. Your short position is up against the management of fslr. Therefore, in this contest, we should also assume your opponent (fslr management) is reasonably intelligent and is aware of the challenge (unless you can strongly demonstrate otherwise). In this case, there is a large number of corrective strategies for the management to pursuit (i.e. a pool of potential corrective strategies). Some of the strategies in this pool will fail miserably and will send fslr down to nothing (or $10). While others will succeed beautifully and allow fslr to keep it's market valuation. Still other strategies will fall some where in between success (fslr at current market value) and failure ($10 or less).

I don't know the probability distribution of the potential strategies in this pool of strategies. I have no reason to believe there are more bad strategies in the entire pool of all available strategies (or more good strategies). Absent such information, the reasonable assumption is the strategies are evenly distributed. In this case, the expected value of all the strategies in the pool is fslr taking a 50% cut in market value. Using latest price, that would be approximately $70.

Actually, I do expect good management to bias the probability distribution of the pool of available strategies toward more good strategies. The $70 estimate is probably low.

It gets worse.

The above assumes your thesis is correct with 100% probability. But it is not 100%. Let's say your thesis has a 90% probability of being correct. If it is correct, fslr is worth $70 based on the above analysis. In the 10% chance of your thesis is wrong and no corrective action is necessary from management, fslr is worth today's ~140 price.

The expect value is therefore: 90%*70 + 10%*140 = $77

If fslr continues to move higher, the above estimate will correspondingly move higher.

It gets worse still.

Things that affects the probability are:
1. quality of management - As mentioned above, good management will discard many of the bad strategies and considerably bias the remaining pool with good strategies. The track record of the management so far is good.

2. financial condition - money in the bank and high stock price means more strategy options and time for the company to execute

3. market condition - renewable energy is currently a rising tide that is lifting all boats.

Today, all 3 of these are on fslr's side and against the short seller.

In summary, time and tide is against the fslr short seller and the risk/reward is not appealing enough. The only way to assume fslr is worth $10 is to expect the outcome to be binary which is very unreasonable.

Note, just to be clear, I am sure you already know, the available strategies need not be technology based. For example, if fslr is indeed over value, a good strategy may be for fslr to use it's stock price to acquire a nuclear energy company or a competitor.

John Hempton said...

I agree that $10 is tough - but it is the institutional imperitive to keep doing things.

The worst case is that

(a) the existing plant becomes non-viable because they are the high-cost producer against the Chinese

(b) they blow $1 billion of cash fighting the inevitable.

Circuit City wound up in this position. When I first visited Circuit City they had a problematic business and a billion of cash representing PAST PROFITS. It did not stop them going to zero. What you had was institutional imperitive blowing through a glorious past...

But my guess is obsolescense is quite fast from here - and I think $77 is unduly fat.

But - hey - they are not obsolescent yet - so I am talking direction NOT position.


狂猪 said...

Hi John,

I think historical data strongly argues institutional imperative is really not a good argument to short a company.

Any company, a technology company in particular, that has been around long enough will eventually face challenges to it's survival. The companies that failed are no longer around. The ones that are still around are the ones that have adopted. We cannot predict a company will fail because of institutional imperative. We can only claim a company failed because of institutional imperative after the fact. The term institutional imperative is only applicable when looking backward.

For every example such as Circuit City, there is a counter example such as Microsoft! In the mid 1980s, Microsoft had the DOS operating system which had a text based user interface. Text based OS was definitely headed toward obsolescence. GUI based OS was the new direction being first developed by Apple. Microsoft adopted beautifully to the changing competitive landscape and we know the rest of the history. Notice because Microsoft recognized the threat early we don't think of the GUI vs text UI a survival challenge but it really was! Where would Microsoft be without GUI?

Speaking of Apple, it too survived it's survival challenge around 1997. However it took a near death experience to turn things around. Back than there were very few reason for Apple to exist. I don't think a strong argument can be made that Apple had a lesser challenge in 1997 than fslr faced today. But Apple survived nonetheless. If we take a look at the stock price around 1997, any short seller should be satisfy with a 50% return shorting apple. There is no way to time perfectly. Any more greedy and Steve Job would have shafted the short seller.

At any rate, there are many potential outcomes.

I do agree with your directional view.

Nick said...

John, thanks for the education on this perhaps you can get a book out of it too.
However, one scary admission from you is that panel prices are surprising you on the upside.

FSLR is a lovely simple company at the topline with two variables: units x price.
Units were well telegraphed by capacity plans so easy to calculate.
That leaves ONE variable to worry about.

Did you spend any time talking to German panel buyers or notoriously loose-lipped Chinese panel makers?
Surely 30mins with a GLG contact would have resolved that covering ahead of Q2 results might be prudent...?
Everyone knew about the FiT reduction from July, so Q2 was always going to be good on pricing... IMHO.

John Hempton said...

Yes - I talked to installers. Not German ones though.

I think a lot of the upside in panels is fixed price contracts signed a while ago - or captive demand.

The price of a panel in the First Solar results is higher than spot prices.

Do not for a moment think I did not do that.


Nick said...

Just checking!
In that case your short makes even more sense since FiT's only go one way in the long term and captive prices can only disconnect for so long...

So far, everything you say makes sense. I used to think that the PV equivalent of Moore's Law would mean that even if we mere mortals think you can't squeeze any more transistors on that silicon/efficiency out of that CdT somehow the boffins would do it. But FSLR's own performance is clearly wanting vs. their own guidance.

Two questions remain; the price of poly and the module price.

One risk to the short is that the module price is simply set by electricity prices, particularly as we hang out relatively close to parity.
Of course, they are extremely biased but every solar exec I spoke with believed that once you were <parity, demand was effectively limitless since every rational consumer would want to install solar immediately to lower her utility bill.
At that point, again, price was determined by electricity not Chinese return on equity requirements.

Can't China remain sold out at prices just below parity for some considerable time?

Potato said...

Wow, didn't take too long for that spike after the quarterly release to ease off. Hope the short term didn't burn your short too much!

Jon said...

I can't say that I disagree with your general thesis at all though I do wonder whether the firm may not surprise slightly in terms of driving innovation and getting more out of each module at a slightly better rate than you predict. It may be pushing a stone up a hill over the longer run, but could mess with the numbers over the shorter run.
I also note with great interest a comment in the Financial Times today (May 10th) containing a market forecast by TK Kallenbach of First Solar that "on balance the danger this year was one of under-supply rather than overcapacity".
You may yet have to wait a while for this one to pay off.

狂猪 said...

Hi John,

What do you think of the idea of using options to execute the short against fslr?

The idea is to write a LEAP call options that expire on Jan 20, 2012.

The advantages over a regular short against the stock are:
1. it has a negative carrying cost. you earn significant time value while carrying the short call position
2. expiration dates in Jan 2012 is plenty of time for your thesis to play out.
3. your lost start at strike price + option premium at the time of expiration. In other words, if the thesis or timing is off, your lost is less than a short against the stock.

The one disadvantage is the maximum gain is limited by the option premium you collect. However, the premium is high. You can also match strike price close to my expected fslr price mentioned previously (but not your very low $10 per share)

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