Why is Trina Solar so cheap?

Yesterday, we argued that Trina Solar (TSL) is very cheap, in absolute terms as well as relative to it’s peers. What we didn’t answer was why this is the case. 

With earnings estimates for this year of anything between $3 and $4 per share and the stock price now below $30, this is a company that sells for less than 10 times the expected profit for this year, and you will have noticed that the year is already half gone, so it’s not even that much of a forward price/earnings (p/e) ratio.

This sounds more like the p/e of some highly cyclical company like steel. From the p/e alone, you wouldn’t guess that this is in fact in a sector which is poised to take off seriously as a result of a couple of fundamental forces:

  • Technological improvements making it ever more competitive against traditional energy sources
  • Traditional energy sources becoming ever more expensive
  • The world economic growth increasing the demand for energy structurally
  • Pollution and climate change problems increasing structurally the demand for clean sources of energy.

You might also have to realize that TSL’s revenue and profit growth this year will be in the triple digits, hardly the cyclical industry suggested by it’s p/e. It might not maintain such a dizzying growth rate next year, but another 50% should be eminently doable.

Also, is there a lot of uncertainty that warrants such an enormous discount? Hardly. Almost all 2008 output is already sold. Almost all it’s main input (polysilicon) for 2008 (and a good deal of that needed in 2009) has already been contracted for.

Let’s go to some other possible explanations:

  1. Too dependent on government incentives
  2. Entry barriers will be too low when the shortage in polysilicon ends, leading to a possible shake-out in the industry.
  3. The solars are (unjustly, in our view) perceived as risky, whenever the stockmarket goes into sell-off mode, the whole sector sells off heavily as investors become risk averse

Before we discuss these theories briefly, one has to note that these are applicable to the whole solar industry, not just to TSL. They would be able to explain why the industry is trading on cheap multiples (which it isn’t, mostly), not why TSL trades at such a steep discount to its peers.

The first theory states a fact, indeed, at present, solar cannot compete price wise with traditional energy sources, so it’s indeed dependent on government incentives. These are the outcome of unpredictable political processes.

However, the trend is towards greater incentives, not less. Germany, Spain, and Japan are the biggest solar markets because of rather generous incentives, but other countries (like Italy, where TSL just got a $150M order) have realized this and are starting to follow.

If you have followed the industry for the last couple of years or so, you will have noticed that the role of US  (Federal) incentives seem to play a disproportionate role. At present, the incentives that are in place until the end of this year have still not been renewed, causing considerable damage to the alternative energy sector in the US.

Although the present US administration might be too wedded to the petroleum sector, this is not necessarily the case with the next one. There is no guarantee, but rationality might prevail at a certain moment. Also, the world is larger than just the US alone, although we have noticed the disproportionate effect of the uncertainty surrounding these incentives, we do think their real-world effect is exaggerated.

The second theory, which we already have discussed before, is that it’s possible that the end of scarcity in polysilicon will so lower entry barriers that the industry will be flooded by new players, which could produce  a shake-out in the industry.

This indeed is a distinct possibility, although, as we noted before, there are counter forces, as the resulting price drops will accelerate the inexorable move towards grid parity (solar energy being as cheap as conventional electricity sources), which will also accelerate demand for solar energy.

So the effects of plentiful polysilicon are by no means guaranteed. A shake-out is not an inevitable necessity. And, it’s an industry effect, it doesn’t explain the steep discount at which Trina Solar trades in relation to its peers.

We have to look for some distinguishing factor that sets it apart from it’s peers. One such factor is that TSL has an integrated approach, producing most steps in the production process in-house. This has led to gross margins around 25% (25.8% in the last quarter), which is actually in the top of the class compared to other solars using polysilicon.

The third explanation, the risk-averseness in times of general market difficulties once again pertains to the industry as a whole and it doesn’t make much sense anyway:

  • The sector is a long-term growth story
  • Many of the companies sell and buy forward their output and most important inputs

Another reason for the perceived riskiness of the sector is the high valuations that many solars enjoy. But this is an argument that really does not apply to Trina, quite the contrary, as we have argued for quite some time.

The remaining reason is that Trina is smaller than some, with a more limited float, and not too many institutional investors are following it, or so at least is something one can read on the message boards. But one can also see here that this explanation doesn’t make sense.

On the last count, no less than 85 mutual funds owned TSL, and this leaves out other institutional investors like pension funds.

We can imagine one last explanation, TSL has disappointed in a couple of quarters (Q2 and Q3 of last year, basically). Against that, Q4 was a 25% positive surprise and Q1 of this year also performed better than consensus expectations. But sometimes, reputations linger. We don’t know how much Trina suffers from it, but as you imagine by now, we also don’t have any other even remotely probable explanation at hand.

The bottom line: if TSL performs according to, or above expectations, any lingering doubt that might be present will disappear, and the full valuation gap will assert itself. There is no justification for that gap that we can think of. Sooner or later, it will close.

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