How to Play the Solar Market Now

Chinese solar stocks have been on fire lately. Most jumped by double digits on Wednesday after a similar jump last week, so there's some hope for these companies from investors. So what's going on with these stocks, and how should you play them?

China comes to the rescue
Last week's jump was after news of additional funding to install another 2.8 GW of solar in China. This has investors thinking that China will soak up a lot of the excess capacity at Chinese manufacturers by creating domestic demand.

The problem is, that amount of installations is only about the size of the capacity of Suntech Power (STP), Yingli Green Energy (NYSE: YGE), or Trina Solar (NYSE: TSL), and there's still about 40 GW of overcapacity in the industry. Since shipments are down dby ouble digits sequentially at most manufacturers, it's hard to see how China alone could make up the slack for the industry.

While the subsidy news boosted stocks, so did the news that China would promote bankruptcies and mergers, which was a bit of a head-scratcher.

Let the weak fail
Since most of the Chinese manufacturers have built their capacity with state-run bank funding, the state will have to decide who fails and who doesn't. This is where Wednesday's announcement comes in. China's State Council said it will ban local government support for solar manufacturers, will cut support for the industry, and will let some companies fail.

Investors cheered the announcement, because this is just what the industry needs. Instead of fighting each other, these manufacturers should be trying to make a profit on their own. The big question for investors is -- who will survive?

Here's a look at just how bad the financial conditions have gotten at Chinese solar manufacturers.

Source: Company earnings releases.
Note: Suntech's results for Q2 and Q3 are not reported because of accounting challenges. Debt level noted is for Q1 2012.

There really aren't any sustainable companies in that group, so there's no clear winner from mergers or acquisitions. I find it unlikely that Suntech, LDK Solar, or Yingli Green Energy will have the balance sheets to be acquirers and they're most likely to end up out of business. Unless China forgives their loans, they simply can't make enough money to survive. It's possible that they could be buyout targets, but equity holders will be left with nothing, because no acquirer would take on their huge debt loads. Solar companies with huge debt loads and negative gross margins say -- do not touch!

(JKS -0.34%)

JA Solar, Canadian Solar(CSIQ -3.08%), and Trina Solar are all strong names in solar but they all have terrible margins. These three could be acquisition targets, and combining one or two of these mid-level companies may be something China will consider.

The bottom line is that there's no obvious solution. Right now, JinkoSolar may be in the driver's seat, but that's fleeting, and there's no clear acquisition target unless most of the target's debt is forgiven. Many of these companies will probably leave equity investors completely wiped out. It's a dangerous time to be betting on Chinese solar.

How to play consolidation
There is a way to play Chinese solar consolidation without throwing a dart at the names I've listed. SunPower (SPWR -3.09%) and First Solar (FSLR -1.39%) will both benefit from consolidation and have strong balance sheets and market positions. Even better, they don't have to worry about consolidation in China at all. If it happens, great. If it doesn't, installers will keep avoiding the terrible balance sheets in China.

With the U.S. and Europe expanding protectionism against the subsidized solar players I mentioned in this article's table, First Solar and SunPower are in position to gain more business in these two markets. The U.S. in particular is attractive, and First Solar dominates utility projects while SunPower dominates the residential market.