This Just In: Upgrades and Downgrades

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." So you might think we'd be the last people to give virtual ink to such "news." And we would be -- if that were all we were doing.

But in "This Just In," we don't simply tell you what the analysts said. We'll also show you whether they know what they're talking about. To help, we've enlisted Motley Fool CAPS, our tool for rating stocks and analysts alike. With CAPS, we track the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

Sun spotting
On a truly miserable day for the market, the solar industry saw a ray of sunshine Monday. Seeing the potential for profits at solar power panel maker SunPower (Nasdaq: SPWRA  ) , wafer maker LDK Solar (NYSE: LDK  ) , and thin-film solar power play First Solar (Nasdaq: FSLR  ) , the analysts at ThinkEquity upgraded all three stocks to "buy." Now, you might have expected this to set off a rally in the shares, but it didn't happen. Not one of the stocks TE recommended buying yesterday ended the day in the green. Why?

One possible reason is that no one may know the ratings are out yet. While multiple sources have confirmed the upgrades, Briefing.com does not yet show them as having happened. And as for those who do know that ThinkEquity likes the shares, it could well be that it's the analyst's own record scaring investors away.

Let's go to the tape
Calling ThinkEquity one of the "worst" analysts on Wall Street might be a bit harsh. Fact is, TE's not all that bad an analyst. While only a minority (48%) of its recommendations outperform the market, those that do outperform tend to reward their investors quite well, with the result that your average TE pick winds up outperforming the market by nearly 15 percentage points.

Within the solar power industry, the analyst's performance looks a little like this:

Company

 

TE Said

CAPS Rating
 (out of 5)

TE's Picks Beating (Lagging) S&P by

Power-One (Nasdaq: PWER  ) Outperform **** 139 points
LDK Solar Outperform *** (11 points)
SunPower Outperform *** (99 points)

So one big win, a big loss, and a more moderate laggard. That's what you get with the kind of high-risk, high-reward investment strategy that ThinkEquity advocates. Problem is, when I look at the three stocks TE is recommending this week, I see only the risk, and little potential for reward. The reason, in a nutshell, is this: Valuation matters.

Valuation matters
At first glance, SunPower, LDK, and First Solar look reasonably priced at P/E ratios ranging from 11 to 32. In fact, they may look downright cheap given each company's estimated long-term growth rate in the low 20s. But if you dig a little deeper into the companies' financials, you'll soon see these profits are a mirage.

In each and every case, these companies are overvalued based on their free cash flows. First Solar, while profitable from a "cash profits" perspective, is nonetheless less profitable than its GAAP earnings suggest (as explained further here). As for LDK and SunPower, they don't need even that explanation; they're burning cash, plain and simple. That could turn into a real problem, really soon, because as we learned just this week, there's a cash crunch coming in the solar sphere.

In a report released by solar-stock-picking superstar Axiom Capital on Monday, we read that the governing party in Germany is deep in negotiations with utilities to broaden and accelerate cutbacks on solar subsidies. The measures being discussed include:

  • Increasing the 13% cut in the "feed-in tariff" that subsidizes solar installations, already slated to go into effect Jan. 1.
  • Introducing new cuts to the subsidy mid-2011.
  • A 3-gigawatt cap on the solar power capacity to be installed annually.

It's that last measure that could hurt solar power players the worst, inasmuch as Germany is expected to end this year with perhaps 9GW being installed, and Germany alone accounts for more than half of all solar power that was installed globally in 2010. The upshot of all this: Axiom predicts "the price of solar modules to fall rapidly toward the marginal cost of production (i.e., ~$1.00/watt)."

Foolish takeaway
In an environment of shrinking profit margins, I expect the weaker solar power players are going to start falling out, dying off, and getting snapped up by their sturdier rivals. Free cash flow-negative companies like LDK and SunPower could suffer particularly, while companies that do generate cash from their businesses -- China's Solarfun (Nasdaq: SOLF  ) , JA Solar (Nasdaq: JASO  ) , and ReneSola (NYSE: SOL  ) , for example -- have better chances of navigating the storm and emerging to see sunshine on the other side.

If I were a gambling man -- and to be clear, I do not gamble on solar power; I only see one clear winner in this space, and it isn't any of the companies named above -- I'd be placing my chips on one of these stronger players. Not on First Solar. And definitely not on LDK or SunPower.

But that's just my opinion. If you think I'm wrong, tell me why, either in the comments section below or, if you're feeling lucky, by placing a virtual bet of your own on Motley Fool CAPS.

Rich Smith does not own shares of any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 629 out of more than 170,000 members. The Motley Fool has a disclosure policy.

First Solar is a Motley Fool Rule Breakers choice. The Fool owns shares of Power-One. Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.


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