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I've been covering the solar sector for the Fool for several years now. How many solar stocks have I invested in since that time? Exactly zero.
I've touched upon several reasons for avoiding the space, but I've never collected them all in one place. I actually have more than I can fit in this one article, but I'll try to hit on three of the most persistent, big-picture concerns I have.
Cash me up, Scotty!
When Yingli Green Energy (NYSE: YGE ) came public amid a surge of solar IPOs in mid-2007, I was put off by the fact that the company was reporting positive earnings while consuming lots of cash (hence the share offering). There were actually two concerns entwined in that first skeptical take. The first was a "quality of earnings" matter. The second had to do with the ongoing dependence on external financing.
I returned to this two-fold problem a year later, in a pair of extremely unpopular articles. Given the weak cash flow numbers being reported by shops like LDK Solar (NYSE: LDK ) , I was worried about these firms' fundraising needs. I urged investors to "think about what would happen if the capital markets closed up shop for a while." I was naturally accused of being a "short seller trying very hard to create chaos and panic for self-serving interest." At least I got credit for being a hard worker!
The good news on the cash flow front is that working capital requirements have eased considerably since 2007. With polysilicon now in abundance, once-restrictive supplier prepayments have fallen by the wayside. That's huge for firms like Yingli, which increased prepayments by $200 million in 2007. In 2008, the firm's net cash provided by operations swung from deeply negative to a positive $140.4 million.
We won't have the full picture on 2009 for another month or two, as most Chinese players have yet to file annual reports. If First Solar (Nasdaq: FSLR ) and Trina Solar (NYSE: TSL ) are at all representative, though, the quality of earnings in this sector has improved a great deal.
Scotty? You there, buddy?
With a less constrained supply chain, I'm feeling better about solar wafer/cell/module manufacturers' ability to generate cash flow. Does that allay my concerns about reliance on external financing? Not really.
Look at Trina Solar. The company just filed its annual report, showing cash flow in line with net income. In the section on liquidity, the company noted that it expected its cash, bank borrowings, and anticipated cash flow to meet its cash needs, including capital expenditures, for the next year.
Of course, Trina immediately contradicted that statement by announcing a follow-on equity offering of 7.9 million American depositary shares -- more than it issued in connection with its IPO! What a joke.
Trina is running circles around many of its global rivals, and isn't particularly hard up for cash. If Trina needs to keep tapping the capital markets, I expect its peers to do the same. That can get tough -- and highly dilutive to existing shareholders -- when sentiment sours.
Competition's great -- unless you're one of the competitors
While photovoltaic modules come in a few flavors, solar PV is a highly commoditized industry. In such a business, the low-cost producer wins. Every player is incentivized to slash costs, which conforms to the societal goal of making solar cheaper and more competitive with other forms of energy. This race to drive down the cost of solar has been, and will continue to be, relentless.
I've always doubted my ability to predict the eventual winners of this drag-out fight among the incumbents. While I saw encouraging signs during the sector's darkest hours, I didn't foresee Trina pulling ahead of the pack as strongly as it did. Think about how much the solar market, or the world economy, has changed in the past three years. Who will be on top three years from now? I have no idea.
As if the competitive rivalry among incumbents weren't intense enough, there's also the very credible threat of new entrants. Again, given the potential size of the solar market, this sector is going to keep attracting new firms like moths to a flame. I've written regularly about the solar ambitions of firms like Siemens (NYSE: SI ) , IBM (NYSE: IBM ) , and BYD. There are countless others out there, from small startups with revolutionary ideas to large conglomerates with vast resources. Most likely, the latter will swallow up the former, and then take the product to market. That's exactly what's happened with General Electric (NYSE: GE ) . Having upped its stake in thin-film shop PrimeStar back in 2008, GE says it's working around the clock to deliver a breakthrough product to market.
If you've studied the work of Clayton Christensen, you know how disruptive innovation can turn an industry on its head. GE may not be the one to usher in such a change -- it may only achieve an incremental improvement over First Solar's panels -- but the risk is out there, and I can't quantify the potential impact. Even short of introducing disruptive solar technologies, new entrants will certainly have the effect of driving down industry profit margins.
Not the last word
So there are my top three reasons not to invest in solar stocks: dependence on external financing, intense competition among incumbents, and the threat of new entrants. If you've come to different conclusions on these issues, please share your thoughts in the comments section. We all benefit from a diversity of viewpoints.