The goal of any business is to sell goods or services for more than it costs to produce said goods and services. If you can't sell goods or services for more than their cost you no longer have a viable business.

It should now be clear that Chinese solar companies are no longer viable businesses as they're currently constructed. Not only are margins so low that it would be tough to make a profit, they all have debt that makes them less competitive than healthier suppliers.

The straw that broke the camel's back
I've been negative on Chinese solar for quite a while, but I've generally kept my strongly negative opinions limited to those with so much debt that it's unlikely they could ever compete. LDK Solar (NYSE: LDK) is an easy target and even Suntech Power (STP) and Yingli Green Energy (NYSE: YGE) have terrible balance sheets.

But today's earnings report from Canadian Solar (CSIQ -1.08%), coupled with Trina Solar's (NYSE: TSL) updated guidance on Monday, have me thinking that China's entire solar industry will eventually be bankrupt, or bailed out in some form. No matter what happens, it is unlikely that shareholders will end up with anything.

These two are important because they are top-tier manufacturers and they both have decent balance sheets, compared to every other manufacturer in China. This should make them more competitive on a global market that now values long-term viability (because of warranties) and quality just as highly as cost.

But both Trina Solar and Canadian Solar are reporting terrible numbers for the third quarter when U.S. competitors are starting to see a light at the end of the tunnel. Trina Solar said that module shipments for the third quarter would be between 375 MW and 385 MW, well below its previous estimate of 450 MW-480 MW. As a result, gross margin would fall to between 0% and 1.5%. That's terrible.

Canadian Solar saw shipments fall 7% sequentially to 384 MW and gross margin fell to 2.2% from 12.4% last quarter. I barely need to mention the $45.1 million loss because there's no way a manufacturer can make money with that kind of gross margin.

The U.S. continues to pull ahead
For years, U.S. manufacturers have pointed to unfair subsidies and low costs in China as their greatest obstacle. What was overlooked is that U.S. manufacturers were building technology advantages to compete while China was building commodity panels.

When the industry reached the point where non-cost factors mattered equally, if not more than cost alone, U.S. manufacturers would pull ahead. After all, why would you buy a panel from a company with billions in short-term debt and a meaningless warranty if it only saves a few cents per watt?

In the last few quarters we've seen this dynamic play out in favor of First Solar (FSLR -0.83%) and SunPower (SPWR -2.30%). Just look at the gross margin trajectory over the past year. China is clearly falling behind.

 

Q4 2012

Q1 2012

Q2 2012

Q3 2012

Canadian Solar

8.7%

7.7%

12.4%

2.2% 

Trina Solar

7.1%

5.8%

8.4%

0%-1.5%

Suntech Power

9.9% 

0.6% 

(10.0%) 

n/a

First Solar 

20.9%

15.4%

25.5%

28.4%

SunPower 

6.8%

9.2%

12.3%

12.4%

Source: Company filings.

If Canadian Solar, Trina Solar, and Suntech are posting minuscule or negative margins how are LDK Solar, JA Solar (NASDAQ: JASO), and other lower-tier suppliers supposed to make money? They simply can't survive in the current environment.

The challenge for the future
The other factor that makes me think China will have major problems competing is a coming wave of new technology. GT Advanced Technologies (NASDAQ: GTAT) will soon release its HiCz technology that (if it lives up to expectations) will lead to a jump in cell efficiencies. Companies that have the capital to invest in this new equipment will dominate the next solar growth cycle.

But, as I found out when I interviewed GT's CEO in June, Chinese manufacturers don't have the balance sheets to make this round of investments; demand is coming from Europe, Saudi Arabia, and Japan, not China, who dominated the last cycle. If highly indebted solar manufacturers can't invest in the next generation of solar they'll be pushed off the financial cliff as sales go to more efficient manufacturers.

Foolish bottom line
Most of China's solar manufacturers are functionally insolvent or well on their way there. Without funding from government-run banks and bailouts from local governments many would already be bankrupt. I would stay far, far away from any of these manufacturers.