Betting on Chinese Solar Is a Crapshoot

An increase in shipments should be good for any company, especially a manufacturing company. But even increasing shipments doesn't look like it can save the Chinese solar industry from a prolonged, painful consolidation. The latest evidence comes from Yingli Green Energy (NYSE: YGE), one of the largest solar manufacturers in the world.

The company released preliminary fourth-quarter results, predicting a 40% increase in shipments sequentially, about 100 MW higher than its own estimates. But not even that could bring the company near profitability, something investors should see as a warning sign for the entire Chinese solar industry.

Debt and falling margins
The reason Yingli's results are important is because of the financial position Chinese companies are in across the solar industry. Debt, particularly short-term debt provided by state-run banks, has funded the explosion of manufacturing capacity and it's now drowning companies who can't even sell subsidized product for a profit.

Yingli, Suntech Power (STP), and LDK Solar are three of the biggest solar producers in China and they're the poster children for the excess of the industry. Below is the balance sheet as of the most recent quarter, each owing creditors more than $2 billion with little ability to pay them back.

Note: Suntech's balance sheet is as of Q1 2012, the most recent quarterly report.

Suntech is the only one of these companies even reporting a positive gross margin in the third quarter, much less net income, and we still don't have resolution to charges that will require the company to restate past financial releases.

You would think that increasing shipments would help gross margin but the trend over the past year hasn't shown that to be the case. Below is the sequential shipment growth and gross margins for Yingli over the past year, including their fourth-quarter preliminary numbers.

The numbers are different for each manufacturer but the general trend holds true and it doesn't bode well for China's solar industry.

Technology falling behind
The big challenge for China's solar manufacturers is that they're producing a commodity when others are differentiating their products. Companies use virtually the same equipment to produce products that vary little from company to company and cost is the only thing that materially separates them. That's why panel prices have plummeted as China has built more capacity.

Contrast that with the strategy for U.S. companies SunPower (SPWR -3.17%) and First Solar (FSLR 0.71%), who differentiate with highly efficient products and extremely low installed costs respectively. Despite higher costs SunPower has managed an 18.7% gross margin and First Solar has a 28.5% gross margin, both exceeding all Chinese rivals.

As the next generation of equipment from GT Advanced Technologies (NASDAQ: GTAT) comes out later this year, Chinese firms will fall further behind from a technological standpoint. Firms have invested billions in older equipment and don't have the capital to buy new equipment now. They'll slowly be left in the dust as competitors build better equipment with higher efficiency at lower costs.

Cost matters less every day
The final challenge after the balance sheet and technology challenges facing Chinese solar is cost. The cost of an individual module on a cost per watt basis matters less and less every day. What really matters is the power you can get from an installation and the cost of that installation, which is why efficiency is so important.

This past October I wrote an article titled "2 Things Every Solar Investor Needs to Know" that highlighted exactly how a more expensive, more efficient panel can produce energy at a lower cost than commodity panels coming from China. Going forward, efficiency will matter even more, which is why China will continue to fall behind as the next generation of equipment is built.

Foolish bottom line
Winning in solar isn't just about picking the best stocks, it's about avoiding the ones doomed to fail. There will be a company or two who emerge from China, there's no doubt about that. But with debt mounting, margins falling, competition improving, and the country's cost advantage eroding it's not worth throwing a dart at the potential survivors and betting on who China will let survive. I would stay away from Chinese solar stocks altogether. It's a gamble you're unlikely to win.