SolarFun (SOLF), a Chinese manufacturer of polysilicon-based solar modules, recently announced financial results, which were greeted negatively by the market, but which were actually positive in certain respects. Specifically, the company’s detailed breakdown of capital outlays into cap-ex and pre-payments to suppliers, provide a more accurate measure of the company’s true profitability, and give some indication of future financing needs and cash-flow potential of SOLF. In addition, the deal with Q-Cells and the company’s gross margin projections for 2009, both signal interesting possibilities over the next year. Combined, the above factors can provide certain guidelines of how to speculate, and hopefully make money, in SOLF’s stock going forward.

As we’ve noted in past reports, we believe that operating cash-flow before expansion cap-ex is the key number to use when evaluating many of these Chinese polysilicon-based solar module manufacturers, as the accounting earnings are extremely overstated due to the pre-payment cash-outflow issue. Unfortunately, the lack of disclosure of these pre-payments and a figure for actual operating cash-flow at many companies, makes it difficult to evaluate these companies and my suspicion has always been that the companies profitability is significantly overstated. However, new management at SOLF (new CEO was hired back in January) is now providing excellent transparency into SOLF’s cap-ex and prepayments, which makes me more inclined to speculate in SOLF as opposed to other Chinese solar companies.

Getting to SOLF specifics:

Basic Capitalization Figures:
63 million shares outstanding. $153 million in cash (including the recent raise) and $360 million in debt (including converts).

Results analysis:

Capital outlays during the second quarter totaled US$ 57.2 million, of which US$ 42.4 million was for capital expenditures and US$ 14.8 million was for pre-payments to suppliers.

Note: Operating profit was $17 million during the quarter, so cash-flow from operations before cap-ex was $3 million, and after cap-ex was -$40 million. It is notable that the company did breakeven this quarter on a cash-flow basis before expansion cap-ex.

For the remainder of the year the company says:

Capital expenditures for the remainder of 2008 are anticipated to approach US$ 90 million, and an additional $70-$80 million for supplier prepayments and the LYG equity acquisition.

Note: Working thru the company’s projected numbers, I estimate the following for the second half of 2008 (only using Photovoltaic modules revenues here, as cell revenue are seemingly non-core):
Total revenue second half should be about $400 million in modules (97MW at $4.15 ASP). At 15% gross margin $60 million in gross profit and 20 million in opex brings me to $40 million operating profit. However, $75 million of that is going to prepayments and LYG, so actual operating cash-flow is negative -$35 million. Including cap-ex total cash outflow will be about -$125 million.

The company currently has about $153 million cash, after the recent secondary, implying that they surely do not need to raise any more money in 2008. However, they will run out of cash early in 2009 and will need to raise more money. How much more money is the real question.

Looking ahead into 2009:
My quick estimates are about $1.1 billion in revenue (Assumptions are 270MW and $3.85 ASP – so 50% increase in MW from 2008 and 7% decline in ASP price), and $145 million in operating profit before pre-payments, cap-ex etc. (assumptions are 19% gross margins and 5% op-ex as a % of revenue).

As to cap-ex and prepayments next year, I don’t have a clue. But, I guess it’s safe to estimate that cap-ex will be about $100 million. The company did say on the conference call that they expect moderated cap-ex in 2009.

The question mark is really prepayments. Does the company’s prepayments in 2008 cover them for 2009? Will an increase in polysilicon supply in 2009 lessen the impact of prepayments in 2009? Will the company’s increase in wafer capacity (of nearly 40%) also lessen the prepayments?

I don’t really have an answer to these questions, but my belief is that, based on the above operating profit number, and considering the fact that the company did actually breakeven this quarter on an operating cash-flow basis, the company may conceivably cover most of the prepayments and cap-ex in 2009 with operating profits, implying that there may not be a need to raise much more money in 2009 ($50 million??).

Considering the above uncertainties, it’s probably best to assign a low-end 5 multiple to my estimated 2009 operating profit number, which yields a price of $725 million for SOLF. Subtracting out debt of $360 million, yields a downside enterprise value of $365 million or about $6 per share.

On the upside, if my suspicions are correct concerning future financing needs, I would assign a 10 multiple to my 2009 operating profit number, yielding a value of about $1.5 billion or an enterprise value of about $1.1 billion, i.e. $17 per share.

Assigning a 50% probability to each scenario above, implies a fair value for SOLF at about $12 per share.

However, these numbers do not reflect the takeout value potential of SOLF, which has risen following the company’s module deal with Q-Cells. Assuming a possible takeout somewhat skews the probability percentages and multiples. I would guess that in a takeout SOLF could be worth about $25 or about 1.5X EV/Estimated Sales. Combining this number with the above would imply a fair value of about $16 for SOLF. Of course, this number again assumes certain probability percentages and depending on your belief of a takeout for Q-Cells will determine the fair value.

This brings me to my trading strategy for SOLF in the year ahead. If the stock drops significantly below $16 (figure 20% or so), it’s a good gamble, given the company’s improving financial results in 2009 and potential takeout by Q-Cells.

In case, you’re wondering about assigning somewhat arbitrary multiples to revenue and operating profit, rest assured that given the uncertainty surrounding future business and cash-flow, the above analysis is basically what financial people at Q-Cells and the investment banks will do in the event of an acquisition. The spreadsheets in presentations may be more complicated and the actual numbers maybe more accurate, but in essence nobody really knows how to value these companies and so financial analysts simply need some multiple number to justify the purchase to their bosses (and then back it up with complex spreadsheets). As such, I think the above multiples are to some extent usable for gambling on SOLF stock, and probably a bit conservative when you take into account the comps.