Why First Solar’s Expansion Plan Isn’t a Slam Dunk

The U.S. utility-scale solar market is currently a big, but finite market for solar panel manufacturers. Given the rising cost of solar panels because of import tariffs there probably won't be much expansion over the next three or four years. 

It's this finite market that First Solar (FSLR 2.52%) is trying to expand into to capture as much value as possible while competitors are hampered by solar panel import tariffs. But with the announcement of a new 1,200 megawatts (MW) solar panel manufacturing facility in Lake Township, Ohio last week, First Solar may be expanding to the point where it will see diminishing returns on its own growth. 

Image source: First Solar.

How First Solar hits diminishing returns

Solar tariffs of 30% on solar panel imports have given First Solar a big advantage in the U.S. solar market. Its thin-film panel construction wasn't included in the scope of tariffs, so all of the company's products can be sold in the U.S. tariff-free. The advantage should lead to strong pricing and margins in the utility-scale solar market where First Solar sells its product.

To illustrate the expected margin bump, First Solar had a gross margin of 6% on solar panel sales in the first quarter of 2018 but expects gross margins to increase to over 20% in coming quarters as higher sale prices from bookings over the past year flow onto the income statement. But there's a limit on the opportunity for higher margin sales to the size of the U.S. market. 

According to GTM Research, the utility-scale solar market was 6,200 MW in 2017 and is expected to be flat in 2018. Projections are for 17% growth in 2019 to about 7,300 MW and flat then flat installations thru 2021. 

Over the same timeframe, First Solar expects to increase production to 7,600 MW, or more than the size of the entire U.S. utility-scale solar market. On top of First Solar's tariff-free production, there's a tariff exemption for 2,500 MW of solar cells imports, which can then be assembled into solar panels by domestic manufacturers, and a 550 MW plant in Oregon that SunPower (SPWR -8.64%) recently agreed to acquire. From just the cell exemption and SunPower's Oregon plant, there could be 3,050 MW of tariff-free production in the U.S. Note: There's not currently enough solar panel manufacturing capacity to turn exempted cells into solar panels, but capacity is being built so I'll use the 3,050 MW figure for illustrative purposes as a proxy for potential U.S. production. 

In the table below, I've laid out First Solar's production based on what's expected to be operational at the beginning of the year and the potential tariff-free solar panel production compared to the total utility-scale solar market size. There's a small percentage of First Solar's production that will be sold into international markets, but recent bookings suggest a vast majority of solar panels will be sold stateside in the next four years.  

Source: First Solar earnings presentation, GTM Research U.S. Solar Market Insight 2017 Year in Review. Calculations by the author. 

You can see that in 2018 there's clearly a shortage of tariff-free solar panels of about 1,150 MW. This shortage has worked to First Solar's benefit, driving 10,600 MW of backlog at high panel prices as developers lock up supply for their projects. But over the next few years, the shortage may turn into an oversupply of tariff-free solar panels. In 2021, there could be 3,350 MW of tariff-free supply if we include all of First Solar's production, tariff-free cell imports, and SunPower's 550 MW of domestic production. It'll be tough to maintain premium prices as new capacity comes online and that could be one reason First Solar's stock is down since the capacity expansion was announced. 

Any anticipated oversupply could hurt First Solar's financials because it still has about 12,000 MW of solar panels to sell before tariffs expire. If those sales are made at prices that lead to margins below 20% it would show signs that First Solar potentially grew production too quickly for its own good. 

First Solar may turn elsewhere for sales

If First Solar produces more solar panels than the U.S. needs it doesn't mean First Solar's product will go unsold, but it may mean any incremental sales from the new plant will generate a lower margin than previously planned capacity. First Solar could sell its panels in international markets, where the company doesn't have the same tariff-induced price advantage.

What I would worry about is that the 6% solar panel gross margin in the first quarter of 2018 is more indicative of margins outside of the U.S. than the 20%+ gross margin managements from bookings within the U.S. If incremental new sales from expanding capacity is sold at a high-single digit or low-double digit level, it would make the expansion of production announced last week a little less attractive than it may have seemed on the surface. 

First Solar had little choice but hit the gas on expansion plans

If you want to know why Wall Street isn't cheering another capacity expansion at First Solar it's likely because the company may be expanding more quickly than investors think is economical. First Solar has seen a windfall of bookings and investors are expecting high margins and profits while tariffs are hitting the company's competition. If First Solar expands beyond the total market capacity in the U.S. it runs the risk of sacrificing margins in the future. 

With that said, I think management is still making the right move by building new capacity when visibility on demand is high. With over $2 billion on the balance sheet, there's a lot of underutilized capital on the balance sheet and that may be driving the decision to expand capacity. And tariffs are currently due to expire in February of 2022, so they won't shield the company for long. But there are certainly risks in the growth strategy and I think that's why the market is selling off First Solar's stock right now.