Canadian Solar (NASDAQ:CSIQ) is one of the largest, and most misunderstood, companies in the solar industry. It's a massive solar module manufacturer and a growing player in the downstream market. But it makes those products in China, and since it gets most of its funding for manufacturing in that nation it's more of a Chinese company than it is Canadian, despite it's corporate headquarters in Ontario.
This dynamic of being partially Chinese and partially Canadian plays into the misunderstanding of the company, especially since "Canadian" is in its name, and it plays into the company's risks as well. Here are the three biggest things I worry about with this company.
Loss of high-margin projects
Canadian Solar has become increasingly reliant on building solar projects for revenue and profit, which has been a great strategy in the last few years.
In the fourth quarter of 2014, Canadian Solar sold 50 megawatts of utility-scale projects in Canada for over C$311 million, or about $245 million. That's an incredible $4.90 per watt, about double what it could get for a competitively built project today. These high-margin projects exist due to power purchase agreements signed years ago in Ontario at rates well above the market and requiring local content. Canadian Solar, it just so happens, was one of the only companies qualified to compete.
Compare the project sale price to the $4.98 per-watt midpoint of SolarCity's (NASDAQ:SCTY.DL) anticipated sale price for residential solar systems in the U.S. and you can see what a windfall these projects are. Utility-scale systems should be considerably cheaper than rooftop residential systems, which require much higher labor, equipment, and permitting costs per watt.
An even better comparison would be the most recent Solar Market Insight report from GTM Research and the Solar Energy Industries Association, which says utility-scale systems with tracking cost just $1.83 per watt in fourth-quarter 2014. That suggests Canadian Solar likely generated extraordinary margins from its Canadian projects.
The impact on recent profits can't be understated. Let's assume Canadian Solar has a higher cost structure than average and it costs the company a plausible $2.45 per watt to build a utility-scale system in Canada. The company would have generated about $122.5 million in quarterly gross margin from its Canadian projects, which was 66% of the company's gross margin for the quarter.
Having high-margin projects is great, but it's likely a short-lived windfall. At the end of 2013, Canadian Solar had 310.7 MW of project backlog in Canada, but that fell to 127 MW by the end of last year, all of which was included in the 2013 backlog figure. That's right, the company in 2014 did not add a single new project in Canada.
The high-margin projects are drying up fast, and by the end of 2015 they'll be gone entirely. Long term, Ontario is moving to a more competitive bidding process that will drive down Canadian Solar's ability to generate high margins. That could eat up most, if not all, of the company's profits.
Canadian Solar is known as one of the leading solar manufacturers in the world, yet it spends very little on research and development that would improve its products. In 2014, it spent just $12.1 million on R&D.
It has essentially taken the same strategy as manufacturers such as Trina Solar and Yingli Green Energy, which involves taking short-term loans from Chinese banks to build a massive amount of solar capacity using relatively standard equipment.
The result is that Canadian Solar makes a commodity solar panel that varies very little from other top-tier suppliers. Its highest-efficiency commercial module is a 16.79% efficient module, which falls well below products from industry leaders. SunPower (NASDAQ:SPWR) makes a 21.5% efficient module today, and even SolarCity's Silevo acquisition aims to make panels that are roughly 18% efficient.
To put Canadian Solar's $12.1 million R&D investment in perspective, First Solar (NASDAQ:FSLR) spent $144 million on R&D in 2014 and SunPower spent $73.3 million. Spending fractions of your competitors on R&D isn't a great path forward in an industry in which technology is becoming more important every day.
A high-risk balance sheet
Most manufacturing companies that use debt to fund manufacturing plants do so with bonds that provide financial stability for many years. Canadian Solar has used short-term borrowings, primarily from Chinese state-run banks, to build manufacturing plants and fund operations. Short-term debt can dry up quickly making this financing strategy a huge risk over the long term.
At the end of 2014, the company reported $725.5 million in short-term borrowings and $801 million in accounts and notes payable. It had just $284.3 million in convertible notes and long-term borrowings.
What happens if banks decide to stop funding Canadian Solar's operations suddenly? What happens if a financial crisis causes a lending slowdown? Canadian Solar could see funding dry up almost overnight, not a position I'd like to be in.
A high-risk solar company
Canadian Solar certainly has its share of risks, magnified by its complex Canadian-Chinese structure. In many ways, it is beholden to the Chinese government and its decision to fund manufacturing through the nation's banks, just like competitors Trina Solar and Yingli Green Energy. In that respect, and based on where its employees are located, this is more of a Chinese company than a Canadian company.
That could change your perspective on the stock. When you consider that the windfall from Canadian projects is nearly over, the stock will be a lot more expensive than the current P/E ratio of eight makes it look.
Travis Hoium owns shares of SunPower. The Motley Fool recommends SolarCity. The Motley Fool owns shares of SolarCity. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.