Suntech

[tucker]

Those of you who have been with RainFrog long enough may remember our first investment. In December of 2001 we bought shares of AstroPower for $40.50 per share. We sold the stock a little over two years later – for 18 cents. When we invested in 2001 AstroPower was one of only a few alternative energy companies achieving positive earnings. However, the company proved unable to sustain profitability in an industry with intense competition and a dependence on government subsidies. AstroPower’s fall caught investors off guard, all the more so because there may have been some accounting irregularities, and many investors who had been enthusiastic about alternative energy were scared out of the sector.

Over the past several years, RainFrog has invested in solar power indirectly through companies like Distributed Energy and Hawaiian Electric Power, but we haven’t held a pure-play solar company since AstroPower. The companies that have been available have either seemed too expensive (e.g. SunPower) or too far from profitability (e.g DayStar and Evergreen Solar). However, over the past year several profitable solar companies have appeared on the US market. The common theme linking these new companies (other than profitability) is that they are all based in China.

Although RainFrog doesn’t have any partners in China, the partnership has been enthusiastic about investing in China in the past. China’s low per capita GDP stems as much from 150 years of exploitation by the West as in does from 50 years of authoritarian rule, and there is some argument that Western capital has a responsibility to help rectify that situation. At the same time, China is the world’s largest country and it is expected to develop rapidly over the next several decades. To the degree that the impact of Chinese development on the environment will be a global issue, we have a vested interest in helping to make that development as green as possible. Investment in China’s solar industry may be a way to effect both of these ends.

Suntech Power Holdings, Ltd. (STP)
Recent Price: $36.22
Revenue: $470mil
Market Cap: $5.42bil
EPS: $0.56
Shares Outstanding: 149.5mil
P/E: 64.68
Avg. Volume: 2,357,310
Dividend: --
Book Value: $4.09
Yield: --

My original intention was to present research on several of the Chinese solar companies at once. In fact, I have already collected notes on several of the companies. However, in the end, I decided to present Suntech separately. For a number of reasons, I believe Suntech is fundamentally different that the other Chinese solar companies. For one thing, it is much bigger. For another, Suntech is truly an integrated solar company. While the other companies are primarily manufacturers producing solar cells in bulk for the German, Spanish, and sometimes Italian and Canadian markets, Suntech also includes significant research operations and a global marketing focus that includes the not only Europe but also the US, Japan, and most importantly, China itself. With this in mind, I think it is worth considering investment in Suntech now, and postponing consideration of the other companies for a future meeting.

Suntech has been in business since 2001, and it was the first of the Chinese solar companies to IPO in the US in December of 2005. It is by far the largest solar company in China (by market capitalization it is almost eight times as large as its closest rival), and it is the 8th largest producer of solar cells in the world. The company has been awarded some of China’s largest and most high-profile solar projects, including an 800 KW building integrated photovoltaic (BIPV) project at Wuxi Airport and the solar installation for Bird Nest Stadium that will host part of the 2008 Olympics. Suntech has sales offices in the US and the UK and operates in Japan through MSK Corp, which it purchased in 2006. The company markets its products through local distributors in Germany and Spain, two leading European alternative energy markets. Historically Germany has been Suntech’s largest market, accounting for 71% of revenues in 2004 and 54% of revenues in 2005. In each of the past five years, more than half of Suntech’s sales have been to five or fewer customers.

Suntech has taken an early technological lead over its competition. Earlier this month, the company announced that its silicon finger technology delivers solar cells that are 18% efficient, 3-4% higher than the market average. (For reference, AstroPower’s cells were approximately 10% efficient in 2002.) Using this technology and economies of scale, Suntech believes it offers the lowest cost-per-watt solar on the market. Both Sharp and Spectrolab (a subsidiary of Boeing) have developed cells with solar concentrators that are 35% to 40% efficient, but these technologies aren’t yet economical for terrestrial use.

In addition to manufacturing, Suntech has made a considerable investment in research and development. While the largest part of the company’s $278 million US IPO went to scaling up production, the company has invested $20 million in R&D with the hope of maintaining or expanding its lead in cell efficiency as well as reducing the resources required to manufacture cells. Suntech has the only credible commercial thin-film solar research program in China. In fact, the research background of Suntech’s CEO Dr. Zhengrong Shi is in thin-film solar development. This could turn out to be very valuable, as many analysts believe that the future of solar is in thin-film devices.

Like its competitors, Suntech has faced a challenge in the past two years in obtaining silicon for its manufacturing processes. As demand for silicon both from solar producers and microchip makers has risen, purchases on the spot market have become increasingly expensive – when they are available at all. However, Suntech began procuring long-term silicon contracts from several different suppliers in 2005, and used approximately 40% of its IPO funding to obtain future contracts. In addition to several small deals with European and Chinese suppliers, the company has a 5-year, US$400-600 million contract to buy silicon from US-based Sunlight Group, and a larger 10-year deal with MEMC Electronic Materials that could deliver as much as US$6 billion in solar-grade silicon. With this, Suntech’s supply problems may be behind them. On the other hand, it is not clear if Suntech is locked in to these contracts. Silicon in its raw form is plentiful, and if the silicon processors are able to increase production more rapidly than expected, Suntech long term contracts may turn out to be relatively expensive.

To date, Suntech’s growth has been spectacular. Sales in 2002, 2003, 2004, and 2005 represented 0.9MW, 6.4MW, 29.5MW, and 55MW respectively. Revenues grew from US$3.0 million in 2002 to US$182 million in 2005, while earnings have grown from US$0.9 million in 2003 to $25.6 million in 2005. In the first quarter of 2007, Suntech anticipates delivering 60-62MW of solar capacity and generating revenues of US$220-228 million. For the whole of 2007, Suntech expects to deliver 250-280MW of solar cells and expects capacity by year-end to hit 390-430MW annually.

For the trailing twelve months Suntech’s profit margin stands at 18.11%, and this is expected to grow as the company scales up production. However, increasing income will be partially offset by increasing taxes. The company paid no taxes during its first two years of profitability, and is paying a tax of 7.5% for 2005-2007. In 2008 the company will begin paying a permanent tax rate of 15%. It is also unclear how further appreciation of the Chinese yuan will affect Suntech’s performance. To the degree that Suntech sells its products in China, increases in the yuan will make earnings relatively more attractive when stated in US dollars. However, a rise in the yuan versus the Euro will pinch export margins. The conservative approach would be to assume that the rise of the yuan will dampen Suntech’s growth, although there is room for positive surprise as domestic sales increase.

Suntech’s stock price has ranged widely since its IPO at $15 on December 14th, 2005. In the post IPO euphoria the stock rocketed to $44.25, but settled back to $22.41 six months later (coinciding with the end of the company’s lock-up period). By last week the stock had climbed again to $38.24 before closing at $35.88 on Friday after Cheng Siwei, the vice-chairman of the standing committee of the Chinese National People's Congress, commented that there may be a bubble forming in mainland Chinese stock markets.

Placing a fair price on Suntech shares will be difficult. The company has been surrounded by hype. For the past year, investors have scooped up anything that has to do with China or the solar industry, and of course Suntech is both. (It is this sometimes unmoderated exuberance for Chinese stocks that was behind Mr. Cheng’s comments last week.) Moreover, company-specific hype has been generated in the US by a few investment advisors who have actively pushed the stock (most notably The Motley Fool), and in China when Dr. Shi was named one of the top 10 Chinese entrepreneurs of 2006. All of this has helped to push the company to its current P/E of 64.68.

Despite its high price, by some estimations Suntech shares may not be overpriced. Consensus growth estimates for the company predict and annualized 55% over the next five years. This would be an astounding rate but may be achievable because the company is starting from such a low baseline revenue. If the company can achieve this growth, and if the shares eventually trade at a P/E of 20, a fair current price could be as high as $76. The fact that oil is trading considerably off of its 12-month high, coupled with Mr. Cheng’s recent comments on the Chinese markets, may make the current price a good buying opportunity.

On the other hand, there are many reasons for caution. One of the biggest is that the solar industry is still relatively immature, and rapid changes in technology or in the market could turn today’s apparent winners into tomorrow’s losers. The relative immaturity of the Chinese business environment adds to this risk. There is concern that the Chinese government may raise interest rates to slow growth of a perceived bubble in the equity market. Moreover, any resurgence in SARS or bird flu in China could create significant instability in the Chinese markets. Suntech will need to deliver almost 35% earnings growth over the next five years to justify its current price, and with the significant risks ahead many conservative investment advisors (including S&P) rate the company no better than a “holdâ€

[jeff_weiss]

A few random thoughts...

FWIW, STP is highly rated on the Motley Fool right now. Everyone seems to be really bullish on this stock. It's the only purely solar company that stock pickers are currently bullish on. People are excited about BP and Kyocera, both of them have plenty of other business besides solar power. However I also saw some discussion about STP using "old" technology with photovoltaic cells and that other companies, such as Evergreen Solar, are further along in developing thin solar film. Any thoughts to add to this?

However, I'm concerned that the price went up 10% today. Was there news that sent the stock up? Did we just miss the boat?

The stock has also been rising steadily since November. So the P/E is past 70, which seems really high. But I suppose that is related to the developing industry it's in. A quick check on P/Es of other solar companies:

Canadian Solar: 121.5
Sunpower Corp: 123.6

Those 2 companies may not be good investments, but nonetheless, STP's P/E is just a little over half of theirs. So that reduces my concern a little.

Jeff

[tucker]

Hi Jeff,

I suppose these aren't "answers" so much as comments...

However I also saw some discussion about STP using "old" technology with photovoltaic cells and that other companies, such as Evergreen Solar, are further along in developing thin solar film. Any thoughts to add to this?

Suntech does have a research shop, which is a plus compared to the other Chinese solar companies (TSL, SOLF, CSIQ, and soon JASO). However, you are right that they lag behind many companies in thin-film development. These include FirstSolar (FSLR), Energy Coversion Devices (ENER), and privately held Nanosolar in the US, BP in the UK, and Sharp (SHCAY and SHCAF) and Kyocera (KYO) in Japan. Dr. Shi has a background in thin-film solar research, so he knows what he is getting into, but there is no hiding the fact that the competition will be intense. If Suntech doesn't make the big technological breakthroughs first (and even if we weight all the research shops equally odds are strongly against them), they will have to match it, license it, or buy it outright. With $5 billion in market cap, they may be in position to give that a try. However, the company lags behind some of its competitors in buying power as well. Kyocera has a market cap of $18 billion, Sharp of $20 billion, and BP of $211 billion. In short, I think it is safe to say that falling behind in technology is the biggest risk for Suntech.

However, I'm concerned that the price went up 10% today. Shocked Was there news that sent the stock up? Did we just miss the boat?

I can't find any news tht might have pushed Suntech up so much yesterday, but all the solar companies went up with them (although to lesser degrees) so I don't suspect it was anything company specific. Part of it might be a rebound from last week's dip, although that wouldn't explain the rise in US solar, and part of it might be rising oil prices because of the cold snap in the US. I wouldn't be suprised to see the stock fall back a little over the next few days, but I could be wrong. Did we miss the boat? Well, if the stock doesn't come back we certainly missed part of the ride. However, this is a boat with a long trip to make - if it doesn't end up on the bottom of the ocean.

The stock has also been rising steadily since November. So the P/E is past 70, which seems really high. But I suppose that is related to the developing industry it's in. A quick check on P/Es of other solar companies:

Canadian Solar: 121.5
Sunpower Corp: 123.6

Like you said, P/Es in the industry run extremely high. Investors are betting that the companies will grow into their P/Es. Some of the companies, like Sunpower, will have their work cut out for them to do that. If SPWR is going to trade at a P/E of 20 in 5 years, the company will have to grow at 50% a year for the next five years just to justify its current price. Others, like Canadian Solar, might make it. (Note that Canadian Solar is expected to earn $0.55 this year, which would bring their P/E right back to earth). Suntech stands somewhere in the middle. They will have to grow at 35%+ per year, but they might be able to do it. Still though, there is a lot of risk to buying a company with a P/E of 70, because is growth slows the price will tumble.

Given the high degree of risk, if we do decide to invest in Suntech we might want to do it with caution. There are a lot of people who have invested a large part of their life savings in this company. I respect their enthusiasm and I hope they will do well. But, I wouldn't do it myself and I certainly wouldn't let my grandma do it.

Tucker

[jeff_weiss]

I found another post on Motley Fool that mentioned that Suntech's American subsidiary recently got SunEdison contracts. I don't have any more information besides that, and I'm hoping that someone has more info.

Since Suntech is a Chinese company, does it hold a distinct advantage over some of the other solar big boys (Kyocera, BP, etc?) when it comes to getting contracts in China? Or is the Chinese market opening up enough that they aren't going to give too much preferential treatment for a Chinese company?

Tucker, I get the impression that Suntech is head and shoulders above the rest of the other Chinese solar companies. Is that correct? Considering that over half of Suntech's revenues in 2004 and 2005 came from Germany, it's certainly not dependent on the Chinese market. They seem to be working all over the world, but where are they concentrating efforts to expand business? Who are their main competitors in those markets?

Sorry to just pose a lot of questions. I don't expect there to be answers, and I can look for some of them later. I'm just typing out thoughts now. So far, it seems like Suntech would be a good investment. I get a feeling that they are much more likely to either #1 or #2 than #3 or #4. 1) continue to grow well, or 2) be purchased by another company that wants better access to the Chinese market, than 3) fall on their face and go bankrupt, or 4) stagnate as other players pass them by.

Jeff

[tucker]

Again, just some comments:

I found another post on Motley Fool that mentioned that Suntech's American subsidiary recently got SunEdison contracts. I don't have any more information besides that, and I'm hoping that someone has more info.

The contract is for $50-90 million of cells mostly for the California market, and is spread out over several years. It is not a tremndous revenue boost. The importance is more of a "foot in the door" sort. The california market is growing, and if this contracts works out there will be more.


Since Suntech is a Chinese company, does it hold a distinct advantage over some of the other solar big boys (Kyocera, BP, etc?) when it comes to getting contracts in China? Or is the Chinese market opening up enough that they aren't going to give too much preferential treatment for a Chinese company?

China is certainly open to buying foreign technology. A lot of foreign alternative energy companies have presences in China (e.g. Nordex, Vestas, the first commercialization of SunOpta's technology for cellulosic ethanol), but I wouldn't be surprised if China had policies to favor domestic companies when they are available. Most countries do. And, even if there no formal policy, there may be a de facto advantage simply because it is easier for a Chinese company to navigate a complex set of bureaucratic rules in Chinese.

The plan for the Olympic installation may shed some light on this. Suntech's contract for Bird Nest Stadium is small, about $1.25 million. There are much larger installations going in. For example, all the hot water for the Olympic Village will be generated by a solar system installed by and Italian company TermoSanitari. An even bigger project (I read 2-3 MW somewhere) will power the lights for the village. I don't know who landed that contract, but I would guess it is someone big enough that they don't feel they need to announce it (Sharp or BP maybe?). However, the solar panels over the doors to Bird Nest Stadium, the ones that 100 million people are going to see on TV next summer, will be Suntech's. I can imagine that there are lots of companies that would have dearly like to have their names up there.

Considering that over half of Suntech's revenues in 2004 and 2005 came from Germany, it's certainly not dependent on the Chinese market. They seem to be working all over the world, but where are they concentrating efforts to expand business? Who are their main competitors in those markets?

Suntech seems to be going after all the world's markets at once, and they have the size and money to give it a go. They announced their new US and London offices within a week of eachother, and they are using MSK to market in Japan. It sounds like there may be plans taking shape for developing countries as well. In my opinion, it is extremely it is extremely important for Suntech that this global marketing strategy is successful. Germany and Spain are great markets, but Suntech doen't have a lock on them. Germany was the top market for all of the publicly traded Chinese solar companies, and several US-based companies as well (e.g. Evergreen), and while the German market will grow I don't think it can supply the growth Suntech needs over the long term. I guess that makes every solar company a potential competitor for Suntech. But, Jeff, I think you are right that Suntech is qualitatively different than the other Chinese solar plays. Myself, I guess their future competition will come more from Sharp than from the publicly traded Chinese companies. Of course, Sharp is probably one of the world's best-managed companies, so competition from Sharp shouldn't be underestimated.