Small Cap Stocks

Introduction

This post is devoted to some thoughts on companies in the solar industry, particularly the Chinese polysilicon-based solar module manufacturers. The basic issue I address here is the risk for a serious cash crunch at some of these module manufacturers given their working capital deficits and their capital expenditure requirements.

Moreover, despite seemingly positive accounting earnings reports from many of these companies, a more careful perusal of these companies balance sheets raises serious questions as to the viability of their businesses, given the continued cash outflows. Importantly, this post does not address thin-film solar manufacturers, and my basic points do not apply to these businesses given the different economics of the thin-film segment of the solar panel industry.

Accounting Operating Metrics Are Misleading

Wall Street’s propensity to value Chinese solar companies off of accounting earnings, MW produced, and other non-cash metrics, completely obfuscates the significant cash-flow problems that many of these companies currently face. The cash-flow issues are caused by significant working capital needs, and it’s hard to imagine how the working capital situation can be improved any time soon, even in the event that polysilicon prices ease. There is simply too much competition in the industry and therefore suppliers, as well as customers, will continue to squeeze these companies on payment terms and cycles.
In the meantime, these companies are only able to keep their doors open due to a continued influx of cash in the form of loans, dilutive equity offerings, and other financial vehicles that Wall Street investment banks arrange. At issue, though, is how these companies would fare, should financing become more difficult. The businesses continue to burn thru so much cash, that it seems very likely that without financing many of these companies would go bankrupt very quickly.

Additionally, since few investors are paying attention to cash-flow, and most reports on these companies focus on accounting earnings and sales, there is a very strong incentive on the part of these companies to engage in questionable sales practices and revenue recognition policies (Note: The evidence for this is somewhat speculative, but is based on countless past examples, in other industries, of major working capital deficiencies signaling suspicious sales activity, such as “channel stuffing” and the like – see below for some interesting comments in SOLF’s 20-F filing).

The Evidence: Risk Statements in SEC Filings

Before getting to specific financial evidence, I’ll address a basic question: Why don’t these companies make money (cash, that is)?

Well, it’s quite simple. They have significant working capital deficiencies that are, and cannot be remedied any time soon, even in the event that polysilicon prices ease.

Here’s how speculative favorite Canadian Solar (CSIQ) explains the situation in the company’s latest 20-F (Note: CSIQ’s situation, is by no means unique, and is shared by nearly every polysilicon based module manufacturer. I have chosen to focus more specifically on CSIQ since it is a company I am more familiar with and additionally it is one of only a handful of companies that has already filed a complete 20-F):

“Advance payments to our polysilicon and silicon wafer suppliers and credit term sales offered to some of our customers expose us to the credit risks of such suppliers and customers and may increase our costs and expenses, which could in turn have a material adverse effect on our liquidity. Under existing supply contracts with many of our multi-year silicon wafer suppliers, and consistent with industry practice, we make advance payments to our suppliers prior to the scheduled delivery dates for silicon wafer supplies. In many such cases, the advance payments are made in the absence of receiving collateral for such payments. Moreover, we offer some of our customers short term and/or medium term credit sales based on our relationship with them and market conditions, also in the absence of receiving collateral. As a result, our claim for such payments or sales credit would rank as unsecured claims, which would expose us to the credit risks of our suppliers and/or customers in the event of their insolvency or bankruptcy. Accordingly, any of the above scenarios may have a material adverse effect on our financial condition, results of operations and liquidity.”

And this from Yingli (YGE):

” Historically, we required many of our customers to make an advance payment of a certain percentage of their orders, a business practice that helped us to manage our accounts receivable, prepay our suppliers and reduce the amount of funds that we needed to finance our working capital requirements. However, this practice of requiring our customers to make advance payments has diminished, which in turn has increased our need to obtain additional short-term borrowings to fund our current cash requirements. In 2007, a small portion of our revenue was derived from sales that required advance payments from our customers. Currently, a significant portion of our revenue is derived from credits sales to our customers, generally with payments due within two to five months. In addition, other customers now pay us through letters of credit, which typically take 30 to 90 days to process for us to be paid. As a result, the general decrease in the use of cash advance payments has negatively impacted our short-term liquidity and, coupled with increased sales to a small number of major customers, exposed us to additional and more concentrated credit risk since a significant portion of our outstanding accounts receivable is derived from sales to a limited number of customers.”

Another interesting quote, relating to the veracity of sales reported in earnings reports and collectiability of receivables, comes from SolarFun’s F-1 filing:

” With certain significant customers, we enter into framework agreements that set forth our customers’ purchase goals and the general conditions under which our sales are to be made. But such agreements are only binding to the extent a purchase order for a specific amount of our products is issued and certain sales terms may be adjusted from time to time. For example, we entered into a framework agreement with Social Capital S.L. under which it agreed to purchase 84 MW of PV modules in total from 2007 to 2008. However, since we could not reach an agreement with Social Capital S.L. on actual sales terms, Social Capital S.L. has not made any purchase order of our PV modules and it is unlikely that it will purchase our PV modules in the foreseeable future. In addition, we have in the past had disagreements with our customers relating to the volumes, delivery schedules and pricing terms contained in such framework contracts that have required us to renegotiate these contracts. However, renegotiation of our framework contracts may not always be in our best interests and disagreements on terms could escalate into formal disputes that could cause us to experience order cancellations or harm our reputation. “

The Evidence: The Financials

While CSIQ reported a huge earnings jump in Q1 2008 of $0.61 per share, the company, in fact, lost a significant amount of money and the earnings number is a complete mirage for significant cash-flow problems. If you compare the company’s balance sheet in Q1 to the balance sheet in the 20-F, the cash-flow issue is quite salient.

Specifically, as of 12/31/2007, CSIQ had approximately $38 million in cash, $59 million in receivables, and $71 million inventories. On the liability side, the company had $40 million in short-term borrowings, $8 million in payables, $75 million in convertibles, and $18 million in long-term debt.

On 3/31/2008, though, after a supposed record earnings quarter, CSIQ reported the following:
$32 million in cash, $119 million in receivables, and $81 million inventories. On the liability side, the company had $71 million in short-term borrowings, $17.5 million in payables, $75 million in convertibles, and $20 million in long-term debt.

Basically, in Q1, CSIQ had approximately a $60 million cash deficit (it’s difficult to get an exact number here since the company doesn’t release quarterly cash-flow statements) because of uncollected receivables. The company financed that huge loss via an additional $30 million or so in debt, and some non-strategic supplier loans (e.g. “accounts payable loans”). Even with all the financing, the company still managed to burn thru cash.

In case, this analysis sounds too shocking, perhaps it’s simpler to just point out that in CSIQ’s 20-F for fiscal year 2007, the company reported a mere $300K loss, or $0.01 per share, on an accounting basis. However, the cash-flow statement in the 20-F shows quite clearly that the company actually lost $80 million in 2007, due to accounts receivable issues and advance payments.

But, CSIQ is not alone. Industry heavyweight Suntech Power (STP) supposedly had earnings of $170 million, or $1 per share in 2007. However, actual cash-flow shows a slightly different story. In fact, STP lost $9 million in cash from operating activities in 2007.

And the list goes on: YingLi (YGE) lost over $300 million from operating activities in 2007, despite claiming a $52 million accounting earnings gain.

Conclusion

In conclusion, as is spelled out in the risk portions of polysilicon-based PV suppliers, and as is evident from annual and quarterly financials, working capital cash-flow deficiencies are a serious financial drain on many of these companies. As such, valuing these companies off of earnings is misleading and vastly overstates the underlying economic value of the companies.

Moreover, considering the tremendous amount of capital expenditures still needed by these companies to ramp up production to meet demand, it should be obvious that polysilicon-based suppliers are starving for cash. However, since the industry is currently oversupplied and suppliers have little differentiation, it seems clear that there is a significant risk that these companies could face a cash crunch should investors grow tired of financing these companies.

Finally, since these companies recognize that Wall Street rarely looks into actual cash-flow, they have every incentive to book unprofitable and questionable revenues, in an effort to produce strong top-line and accounting-earnings growth. Nevertheless, when certain contracts are called into question by customers, and other questionable revenue recognition policies are addressed, companies may need to restate earnings and erase past profits.

Disclosure: I hold no position, either long or short, in any of the stocks mentioned in this report.