The solar industry has been a crazy business to follow since I started at The Motley Fool. Stocks have been crushed, installations have risen, and the cost to install solar modules has fallen dramatically. In many locations around the world, solar power is already cheaper than fossil fuels, and if cost trends continue, grid parity will be reached nearly everywhere.
Despite positive news for the industry as a whole, it hasn't translated to profits or rising stock prices for solar manufacturers. This may continue for some time, but I think now is the time to buy low -- if you can find a company that will last.
The advantage goes to efficiency
There's a lot of talk about how fast the cost of solar is falling, but investors should keep an eye on efficiency. As overall system costs come down, the amount of power you get from a system becomes more important.
Let's use an example to illustrate why efficiency is so important and how it will play a role in the future. The difference in cost between a Trina Solar module and a higher-efficiency SunPower (Nasdaq: SPWR ) module is about $0.50 per watt right now. The efficiency difference is about 5 percentage points (less than 15% versus less than 20%).
Let's assume a 2 kilowatt Trina Solar-based system costs $6,000 to install, with $2,000 for panels ($1 per watt) and $4,000 for balance-of-system costs ($2 per watt). A physically similar-sized SunPower system would cost $4,000 for panels ($1.50 per watt for a 2.66 kW system) and the same $4,000 for balance-of-system costs.
With low-cost 15% efficiency modules, you could generate 3,500 kilowatt-hours per year at a 20% capacity factor. And if you save $0.15 per kilowatt-hour of electricity, this would give you an 11.4-year payback period. The SunPower system would generate 4,660 kilowatt-hours and have the same 11.4-year payback period.
If balance-of-system costs are higher, the advantage swings to SunPower. And as costs fall, the difference between prices becomes lower than $0.50, and the cost advantage will slowly evaporate because efficiency overcomes the higher relative cost. We've seen this play out with First Solar (Nasdaq: FSLR ) , which hasn't lowered cost enough or increased efficiency enough to keep up with higher efficiency rivals.
There are two ways this battle could play out. Chinese manufacturers with lower costs could increase efficiency to overtake SunPower's current efficiency advantage, or SunPower could cut costs fast enough to overtake Chinese manufacturers' cost advantage.
The best solar stock in America
I am splitting my solar picks into American companies and Chinese companies because there are vast differences between the two, which I'll explain later.
The best American stock in my eyes remains SunPower, and the reason I'm picking it is that in the battle I outlined above, costs have proven easier to cut than efficiency improvements have been to make in recent years.
The company announced this week that it had started production on its third-generation Maxeon solar cells, which have an efficiency rating of up to 24%. These cells will make modules that are more than 20% efficient and will be used on the company's C7 tracker, a system that magnifies sunlight on solar cells.
SunPower has reported losses in recent quarters, just like most manufacturers, but it's managed to squeak out a non-GAAP profit of $0.16 last quarter and a non-GAAP gross margin of 12.4%. The high margin level, relative to the competition, will likely continue because much of 2012's demand will come from the utility and power plant business, which sets prices years ahead of time.
The potential impact of SunPower's C7 Track isn't fully understood by the market in my opinion, either. Since the system uses mirrors to bounce the sun's light onto solar cells, the company will be able to greatly expand revenue without expanding solar cell production. This can save capital costs and reduces risk for shareholders.
The company is also backed by Total, an oil company with a huge balance sheet and a 66% stake in SunPower. Total has demonstrated a commitment to keeping the company alive and well, and this could be what ends up separating SunPower from First Solar and Chinese manufacturers.
The best solar stock in China
Chinese solar manufacturers have begun separating themselves into two categories: top-tier suppliers that generate positive gross margins despite challenges, and low-tier suppliers that struggle to sell product at a profit. I'll stick to only top-tier suppliers in my bucket of top stocks because I don't feel that all low-tier suppliers will survive.
Suntech Power (NYSE: STP ) , Trina Solar, and Yingli Green Energy (NYSE: YGE ) are often considered top-tier stocks because of their relative longevity in the market. But I think Canadian Solar (Nasdaq: CSIQ ) is the stock to watch among these companies. Canadian Solar has the highest-efficiency modules among these companies, and it's proven it will do everything it can to advance its technology.
The company also doesn't have a balance sheet weighed down by billions of dollars of debt like Suntech and Yingli do. Trina Solar is also a consideration, but I like Canadian Solar's trajectory right now.
My top solar stocks are SunPower and Canadian Solar, which I've backed up with CAPScalls on My CAPS page, but do you agree? Leave your thoughts in the comments section below, and if you're interested in reading more about these solar stocks, add them to My Watchlist, which will find all of our Foolish analysis on solar.