Auriga: Solar Overcapacity Won’t Be A Problem, Top Picks DQ, SOL, TSL, YGE, STP

Usually, I just posts highlights of the reports from Mark Bachman from Auriga, but this morning decided to just publish in full.  Thoughts?

As the second act of the Italian solar drama begins, we look at the bear argument of "too much 2012 capacity leading to uncontrollable price and margin declines." At the risk of starting a larger food fight, we provide our view on how industry capacity develops and show that actual shipments end up materially lower than stated capacity, and that installations are another step lower than shipments. This does not counter our view of continuing module price declines — lower prices are required to open newer markets and soak up supply — but we think a better understanding of shipments vs. capacity highlights an overcooked argument. We continue to focus on names that benefit from higher polysilicon prices and whose supply chain is minimally exposed to spot poly prices. Our top picks are Daqo (DQ, Buy) and Renesola (SOL, Buy), followed by Trina Solar (TSL, Buy), Yingli (YGE, Buy) and Suntech (STP, Buy).

· Time shift accounts for bulk of apparent overcapacity. It is easy to understand how small differences between stated capacity plans and actual capex progression can lead to lower shipments than suggested by the outright announcements. An aspect rarely discussed is the idea today’s capacity plan addresses demand two years from now. While it is clear that expansion of existing facilities occurs quickly and addresses medium-term demand, it might be more important to compare capacity plans against next year’s demand expectations rather than this year’s expectations; as the solar industry continues to grow, one can argue that suppliers are simply skating toward expected demand. Discussions with companies suggest outsize capex plans are more about capturing peak near-term demand rather than normalized demand, and that out-year demand is expected to catch up.

· Facilities are always underutilized. At the end of 2009, headlines were rife with fearful comments similar to "we only see 8GW demand in 2010, but industry capacity could approach 18GW," reflecting concern about the capacity announcements by major suppliers. The industry ended 2010 closer to 22GW of stated capacity but still exhibited strong prices with demand near 16GW. This discrepancy is likely a result of the near-constant underutilization of the industry as it builds capacity ahead of demand. Looking back, it seems fair to discount stated capacity by ~40% to account for achievable installations in a year (effective capacity is essentially 60% of stated capacity).

· Channel inventory is significant. Comparing shipments to installations, we find a differential ranging from 10%-30%, indicating shipment into the channel accounting for the time delay between shipment and installation. As the market grows, it seems reasonable to assume the percentage of industry shipments in the channel should shrink, but we note that 10% channel inventory in 4Q08/1Q09 resulted in a substantial snapback in 2H09. Current indications suggest channel inventory is once again low, potentially mitigating the apparent overcapacity suggested by industry capex plans.

· Prices should come down in a manageable fashion for low-cost suppliers. The general thesis on solar is that lower prices open more markets, allowing lower margins to be offset by higher volume. We continue to expect this scenario to play out and expect prices to come down over time. While there have been substantial announcements of capacity expansions capable of serving lower priced markets, there is also substantial legacy capacity that is not able to serve these lower priced markets. As more industry focus is placed on newer markets, stagnation in markets served by legacy equipment should lead to a roll-off in high-cost supply. This could be disastrous for companies providing such high-cost supply, but should be manageable for companies whose cost roadmaps match or outpace price declines.

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