Save Yourself From Commoditizing Industries

It's early 2009. You've just witnessed that global solar photovoltaic capacity jumped almost 70% year over year -- a high-growth sector. Even more encouraging is that solar electricity is becoming price-competitive to established fossil fuels and nuclear power, making it a huge potential disruptor to an aging industry. Looking for a top dog, you single out First Solar (Nasdaq: FSLR  ) . Not only is the company one of the largest solar players, but also has technology that allows it to produce a solar cell much cheaper than its competition. You invest.

Fast-forward to today, and you're looking at a 90% loss in share value.

What happened, and what should you take away from this lesson?

An ill industry
Many things went wrong for First Solar. It admitted that its solar technology experiences higher failure rates in hot climates, forcing it to increase the amount it set aside for warranties. A very public and political bankruptcy of Solyndra, which received a $500 million federal loan, brought a dark cloud over the future of the industry. And European governments that are struggling in a rough economic climate have cut incentives for installing solar cells. These issues alone might have been manageable, but the larger issue has put First Solar in its deathbed: commoditization.

The deadly disease
To most consumers today, a solar panel is a solar panel, with the only difference being the price. In other words, solar panels are now commodities. China's solar industry has boomed with help from over $30 billion in government subsidies, and this has produced a glut in the market. According to GTM Research, the global solar industry will have the capacity to build 59 gigawatts by the end of the year, but there will be demand for only 30 gigawatts. Accordingly, the price for panels fell 50% in 2011, crimping margins for panel producers. The U.S. instituted new tariffs on Chinese solar panels to help bolster prices, but this move might be too late for major bankruptcies in the industry.

The lesson
The story of solar panels is not too different from many other products that can be mass-produced and offer nearly identical features across brands. Televisions, computers, and cellphones are just a few examples, with respective losers like Sony, Hewlett-Packard, and Nokia.

How can you avoid companies that are bound for this kind of value destruction? Look closely at brand and management.

The power of a premium brand
Consumers will pay for quality and what purchasing a product says about them. For commodity-like products, quality can be equal across companies, but marketing can push consumers to one brand over another. Take Apple (NYSE: AAPL  ) . According to a SquareTrade report, Apple laptops had a 17.4% chance of malfunctioning over three years, whereas Asus, Toshiba, and Sony laptops all had a lower failure rate. Even so, Apple bests its competitors in perceived reliability in the annual PCWorld survey. This gap between actual and perceived performance can be attributed to marketing. Even if Apple computers don't perform as well, consumers don't see it that way and happily pay up for an Apple laptop. This gives Apple a 30% profit margin, while other laptop makers languish around single digits.

If you can't beat 'em
There are commodities that can't be branded, however, but still offer excellent business models. This is because of great management. Take Nucor (NYSE: NUE  ) , which produces steel. Nucor's organization includes a relatively flat hierarchical structure, performance-based incentives, and pride in never laying off an employee due to a poor economy. With great management and culture, Nucor was able to squeeze a profit margin of 4.3% in 2011, compared to competitor Steel Dynamics at 3.3%. It also helps that Nucor shipped over 20 million tons of steel in 2011, compared to Steel Dynamics shipping just over 5 million tons. With better sales and lower costs, poorly performing competitors are squeezed out of an industry and the winners gain more scale, further lowering costs.

Future commoditization
Can we predict if a new industry like 3-D printing will become commoditized? Profit margins at 3D Systems (NYSE: DDD  ) recently peaked during the second quarter last year at 24%, and have since fallen to 8%, and its competitor Stratasys (Nasdaq: SSYS  ) has also recently trended downward:

SSYS Profit Margin Chart

SSYS Profit Margin data by YCharts.

Fool colleague Alex Planes also writes on the threat of 3-D consumer commoditization:

MakerBot was selling inexpensive consumer 3-D printers when the Cube was just a gleam in 3D Systems' eye, and the start-up is committed to the open-source model. Thousands of MakerBots have been bought since 2009, and the company's Thingiverse already is what 3D Systems hopes its Cubify community will become -- a repository of designs made by loyal users. Shapeways is another 3-D printing design community with quite the selection of designs. One open-source 3-D printing concept, the RepRap, is a self-replicating printer that can effectively print new versions of itself, or at least most of itself. If that's not a threat to the big players, I'm not sure what is.

Really, it's up to management and marketing to ensure the success of these companies. If the brand continues to hold value and that value can be translated into higher margins, companies will succeed. If commoditization is inevitable, efficient management can produce returns even in a heavily commoditized industry.

Apple's premium brand isn't all it has going for it. Get the whole scoop by reading the Fool's new premium research report on Apple. For one stock pick that has very little chance of becoming a commodity, read our free report: "Discover the Next Rule-Breaking Multibagger." This highlights a company following in the footsteps of a proven profitable model.

Fool contributor Dan Newman holds no position in any of the above companies. Follow him @TMFHelloNewman.

The Motley Fool has owns shares of Apple and 3D Systems, has sold shares of Sony short, and has written calls on 3D Systems. Motley Fool newsletter services have recommended buying shares of 3D Systems, Nucor, and Apple, as well as creating a bull call spread position in Apple. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 10, 2012, at 1:11 PM, AstronomyGuy wrote:

    Wasn't it just a month or so ago that DDD was a sleeper waiting to pop?

    Now it's TBA AAC.

    What's up?

  • Report this Comment On July 10, 2012, at 11:08 PM, AbundantlyClear wrote:

    So there is no money to be made in commodities? It seems like Exxon has been the most profitable company on earth in recent years. That might be an over generalization because oil is as generic as a commodity can get and it is currently one of the largest sources of power in the entire world. To under estimate the power and profit that comes from producing world dominating energy power would be a huge misjudgment. We have spent hundreds of billions of dollars in the Middle East fighting other country's wars in a futile attempt to keep those countries at peace, so we can get our oil from them.

    The huge drop in prices to produce solar panels on the surface seems very bad and in the short run makes it very tough for the weaker companies to stay in business. This reality took the air out of the overinflated Solar energy stocks that went up mostly on hope for the future. However, the opposite is true longer term and in fact lower prices will be what makes the solar industry viable.

    How many people were buying plasma TVs when they cost $5,000 for a 42 inch screen 10 years ago? Now that that a much better quality Plasma TV of the same size is available for $300 it went from a rich man's toy to a mainstream product that literally anyone can afford and has dramatically improved the quality of TV viewing for most Americans. Unfortunately it is a bit of a catch 22, because you can’t improve production efficiencies and make it much more affordable to produce things on a massive scale unless you have demand on a massive scale to require the need to produce them at a much higher rate. This demand is what eventually gives a product the critical mass it needs to not only survive but also thrive going forward. The price to produce solar panels has dropped dramatically in the past few years. This is what will propel solar into the future.

    Right now the biggest problem for Solar is that it is too expensive, just like plasma TVs were in the recent past. If they could cut the costs, solar will dominate the world as the clean and cheap energy alternative to Oil, Natural Gas and coal. With current technology, just 300 square miles of solar panels could power the entire world. The more affordable solar becomes the faster it will become the main source of energy for the world. Just like computers and plasma TVs they will get better and cheaper every year. It isn't a matter of if, but just a matter of when Solar power will knock oil and all of our least favorite Middle Eastern countries back into the obscurity they came from and where they belong. The people that control the production of oil are amongst the richest people in the world. I don’t think it is a stretch to think the producers of solar panels can make a sizable profit if they continue to produce the highest quality solar panels at a reasonable price like First Solar has been doing for years.

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