Perspectives on the Recent U.S. Investigation of China's Solar Industry

The solar sector is a rather new, dynamic, and controversial industry. It attracts all varieties of people from casual investors to die hard technology gurus, and because of the endless news flow revolving around the sector it also attracts a lot of media coverage. Since the industry operates in direct conflict with much larger legacy industries that also play a part in the global energy market, the solar sector also attracts more than its fair share of critics. Unfortunately since the industry is so new a lot of information gets misrepresented by sources less informed on the technologies involved. Some of the misinformation is unintentional to be sure, but due to inevitable conflicts of interest a lot of information presented is also purposely misleading. So when news of the US investigating China’s unfair subsidization of its renewable “green” industries, solar investors in the US took the familiar sell first ask questions later path. While these claims don’t solely target the Chinese solar sector, only the impacts to Chinese solar companies are discussed in this article.

The first question that should be asked: does China unfairly subsidize their solar industry? Since it would be too lengthy to discuss every company in the industry, only the largest and most profitable are compared in this article. The most profitable US listed Chinese solar company in 2009 was Trina Solar (NYSE: TSL), and the most profitable US solar company for the same period was First Solar (NASDAQ: FSLR). Since unfair subsidies are being examined, it makes the most sense to look at the most profitable companies. TSL earned $98 million in 2009 while FSLR earned $640 million.

One of the complaints raised is that China unfairly offers tax incentives for its solar companies. In fact, most companies in China pay a standard uniform tax rate of 25%. Before 2008 when China normalized domestic company tax rates with foreign companies operating in China, domestic companies actually paid a higher tax rate. There are exceptions for new enterprises which get tax discounts for their first three profitable years, and there are also special tax rates which apply to certain “high technology” industries which China is actively trying to promote. However, these rates do not singularly target solar companies with exceptional advantages. Tax rates in the US are actually a bit more complicated in nature but similar themes of tax incentives and rebates do apply to select companies. In the case of the two companies mentioned, TSL’s effective tax rate for 2009 was 20.2% while FSLR only paid 6.7% in taxes despite being more than six times more profitable. If any solar company was granted special tax breaks, it wasn’t TSL. In fact, FSLR made more than the net income of every US listed Chinese solar company combined for 2009.

Another complaint is the Chinese government’s subsidization on the cost side of production. It’s true that labor costs are cheaper in China than in the US, but that’s just a function of the global economic environment currently. Labor is also cheaper in other parts of the world relative to China as well. Part of this argument extends to the claim that China manipulates its currency by keeping it at depressed levels. This is an entirely different topic however so it won’t be discussed here. A simple counter argument can be made even if China appreciated its currency to the degree the US has implied, wage differentials between the US and China would still be extremely wide. As far as the crystalline solar industry is concerned, labor is actually a small part of costs for most of the vertical value chain outside of module assembly.

Other parts of the cost equation involve the raw materials in producing solar modules. One of the key components is polysilicon which until several years ago only the most industrialized and technologically advanced countries such as the US, Japan, and Germany held virtual monopolies on its production. Due to the rapid expansion of solar module end demand in the past half decade, the demand for polysilicon skyrocketed. However production capacity for polysilicon did not expand as fast due to high capital costs, technological barriers, and extreme long lead times in construction. This imbalance in supply and demand caused the price for polysilicon to surge over ten fold. Most silicon based solar companies in China ended up paying several times the multiple for polysilicon, including TSL. Western silicon based solar companies enjoyed better pricing terms due to their higher levels of relations with incumbent producers. US based Sunpower (NASDAQ: SPWRA) for example paid half the rate for polysilicon than TSL a couple years ago. There was no Chinese government intervention by means of subsidies here. Pricing and procurement costs were completely a function of the free markets as it always should be.

Much like Silicon Valley is the hub of US information technology where ideas are formed, visions collaborated, and business plans executed at high levels of efficiency and synergies, China is in a sense the manufacturing hub for the global economy. Because so much ends up being manufactured in China, the country has built an extremely efficient supply chain and logistics infrastructure. This doesn’t apply solely to solar modules, but everything else where raw materials need to be collected, processed, and shipped within the supply chain. In the case for solar modules however, the plastics, metals, glass, and other consumables used are simply much cheaper to procure than in other countries. Manufacturing operations in many cases str extremely centralized. TSL is case in point as the poster child of centralization. Being a fully vertically integrated module producer, TSL produces its own ingots, wafers, cells, and modules all at the same location. This saves a lot of time and costs that would have to be otherwise wasted by packaging and reprocessing components within the value chain. To further augment cost reduction, TSL has also set up a manufacturing campus next to their own site so key suppliers could relocate to save on logistics. In contrast, TSL’s direct US based SPWRA’s supply chain stretches between the US, Europe, South Korea, Philippines, China, Mexico, and soon Malaysia as well. Consequently, Sunpower’s module processing costs were and still are much higher than TSL. Part of this is also due to the costs involved with different technologies, but a large part is simply bad supply chain management.

Another interesting claim made is that China subsidizes electricity for their solar companies. It is true that some Chinese based solar companies enjoy temporary electricity subsidies at the local level, the central government does not offer national subsidies. TSL for example, gets no electricity subsidies. Since FSLR and SPWRA manufacture to a high degree outside the US, they are not good comparisons. Hemlock, the largest polysilicon manufacturer in the world by capacity, does manufacture in the US. In a state senate bill passed a couple years ago, the state(Michigan) “to grant a refundable business tax break based on the price it pays for electricity to the Hemlock Semiconductor company and perhaps other producers of polycrystalline silicon used in solar cells and semiconductor chips.” This is not to single out any company but to show that industry subsidization is not a one way affair.

Which country subsidizes who with what is really an endless story. All nations have their governments subsidize particular industries in one form or another on a local or national level. Finger pointing would be an endless task and quite frankly a meaningless one. Perhaps the more important question is what effect US trade sanctions would have on Chinese solar companies? So without assuming blame to either side, nor calculating the probably this sort of action could occur, the impact of the US shutting its doors to Chinese solar companies is examined next.

Currently, the vast majority of solar modules produced end up in the European Union. Germany is the largest consumer of solar modules currently. Last year the US accounted for less than 10% of global solar demand, and that percentage is expected to drop further this year as other regions of the world accelerate their solar deployment. Again, Trina Solar is being used as an example for simplification purposes. One can substitute TSL with any of the larger US listed Chinese solar companies such as Yingli Solar(NYSE: YGE) or Suntech Power (NYSE: STP) to yield similar comparisons.

During 2009, TSL shipped 2% of their modules to the US. This represented about $17 million worth of modules that the US imported from TSL. In prior years, the numbers were even smaller since the company only set up US operations a couple years ago. It’s interesting to note that since the period TSL became a US listed public company in late 1996, the company has provided the US with a large trade surplus since it bought polysilicon and manufacturing equipment from the US but shipped much less finished goods in return. For example, TSL does buy polysilicon from Hemlock, and it sources all its multicrystalline ingot casting furnaces from another US company, GT Solar(NASDAQ: SOLR). This doesn’t even take into account millions US financial firms such as TSL’s US based auditor, investment banks, and exchanges have benefited since TSL became a US listed public company. At least in this case, the absolute dollar trade balance between Trina Solar and the US has been quite a lopsided one where the US has benefited.

TSL does expect its US exposure to increase to 13-15% for 2010 as it expands operations to gain market share. A simple conclusion can be made that if the US closed its doors to Chinese solar companies, TSL would lose 13-15% of its revenue source this year. In reality, the impact is likely to be much less. It’s possible TSL would suffer no impact at all if it could not sell to the US. Part of the reason was detailed above since the US is only a small portion of global solar demand. Global solar demand this year is estimate at around 15 times TSL’s manufacturing capacity, and more than double the combined solar cell capacity of all US listed Chinese solar companies combined.

Based on the most recent round of earnings reports, TSL has the lowest manufacturing processing costs among silicon based module manufacturers in the world. As a result, their unit costs is also among the lowest in the world as measured on a per watt scale. This allows the company to price competitively and sell out its capacity ahead of peers who may have higher manufacturing costs. While the gap between TSL and other top tier Chinese manufacturers is not very large, the gap between it and non-Chinese counterparts is extremely wide. US, German, and Japanese peers price their modules on average at 30-40% higher TSL.

In an environment of booming solar demand as represented currently, everyone including higher priced competition can do well. Many top tier Chinese manufacturers such as TSL have indicated for the past year that they are overbooked and sold out. Because of capacity constraints among lower cost providers, higher cost modules can still get absorbed in a seller’s market. If certain markets decline or get shut off, higher cost producers should be among the first to see their business drop since solar modules are essentially a commodity. Bankability issues do exists but namely for smaller firms, not large scale producers such as the larger Chinese companies listed in the US. Thus with product differential so narrow currently, costs become the main driver on who sells out first.

For a simple analogy, imagine a bus carrying 20 very thirsty tourist stops at a refreshment center. There are 4 venders who each have 5 bottles of water to sell. While the brand of bottled water differ, they are still widely recognized and accepted labels. Three vendors sell their water for one dollar per bottle. Another sells for 1.25 a bottle while the last sells for a high 1.50 per bottle. Since there are enough thirsty tourists, everyone is going to sell out this time. What would happen if the next time only 15 tourists were on the bus? While it’s not always 100% higher cost commodity providers don’t sell, the odds of lower cost providers selling out first is much higher.

A US trade barrier would then only shut off less than 10% of the global market for Chinese producers. Branded Chinese names would simply shift their geographic allocation to other parts of the world as their production capacity is still much less than the remaining 90% open market. Consequently, the US would end up paying more for their solar modules probably from higher cost producers not sanctioned by US trade barriers. In the event demand does not encompass the global supply of both low and high cost providers, lower cost producers will continue to take market share away from higher cost peers. This exact scenario has been playing out since the credit crisis of 2008 shook up the entire industry. Most lower cost providers increased shipments and profitability while many smaller higher cost peers lost share with many even going out of business. There have been big winners and just as many big losers within the industry over the past couple of years. If particular attention is focused on the failures, then an accurate account of entire industry wouldn‘t be portrayed.

Perhaps the most interesting aspect of this drama is the timing of these claims made by the US against China. With less than two weeks until midterm elections in Washington, is it only coincidence that these charges are brought up now? Maybe it’s just political rhetoric ahead of political season, or maybe the US could be embarking on a longer term escalating in trade disputes with China. Only time will tell. Regardless of the real intent or outcome however, until the dynamics of the solar industry demand changes dramatically, top tier low cost providers should still maintain an upper hand as long as demand from open markets remain strong. Since the majority of larger Chinese solar companies are the lowest cost providers in the world, they should be among the last to get pushed out if the industry experiences a negative downturn.

Disclosure: Long TSL, YGE. No position in STP, SPWRA, FSLR.

Author: Investing Hobo

Source: http://seekingalpha.com/article/232009-perspectives-on-the-recent-u-s-investigation-of-china-s-solar-industry?source=yahoo