Solar Power's Growing Pains: Part I

Part one of this series looks at the recent sharp rise and fall of the solar sector and looks two to three years ahead to identify future trends in pricing, demand and what it takes to survive the coming industry shakeout. In part two of this series, look for some of the likely winners and losers in this fast-changing landscape.

The Claymore/MAC Global Solar Energy (TAN - commentary - Cramer's Take) ETF hit a new all-time low on Wednesday, dropping more than 75% from highs touched this summer. In recent weeks, sector players have noted a sudden slowdown in demand and a sharp contraction in pricing.

That's tough news for an industry that is undergoing a massive expansion in production capacity. Rising supply and a slowdown in demand growth are likely to squeeze profit margins and stress debt-laden balance sheets. The good news? Those lower prices are accelerating the time it will take for solar power to become truly cost-competitive with fossil fuels.

Right now, there is little to cheer about in this space:

• Oil is now $55, roughly in the area where interest in alternative energy installations tends to drop off.
• Lending has dried up for many companies in the food chain, in part due to the credit crisis and in part due to concerns that the payback period for installations has just been stretched further with fossil fuel prices dropping. On a related note, any lending that is being done is being done at higher rates, raising the internal rate of return threshold for installations.
• A number of key players in the industry derive a large chunk of sales from Europe and are taking a profit hit from the falling euro.
• Pricing for key raw materials and for finished modules is dropping fast. Average selling prices for solar modules are expected to fall 40% to 50% from their 2008 peak until the end of 2009, and they could fall another 20% in 2010. So potential buyers are waiting to see if they can get an even better price down the road.

Against that backdrop, it's important to note that the global pace of installations continues to grow at a solid clip. The solar industry installed 2.6 gigawatts (GW) of power in 2007, an expected 4.4 GW in 2008, and analysts expect that figure to rise to 7 GW in 2009 and 10 to 11 GW in 2010 despite the current headwinds. (Yet, the falling prices imply that revenue growth will be tepid in 2009 at best.)

Falling prices are certainly manageable for the larger, well-capitalized firms, but they could chase the weaker hands out of the business. Moreover, any start-ups that were hoping to raise capital through debt or equity markets will be hard-pressed to find any interest for at least several quarters, if not more. As a result, the entire solar industry is transforming into the next, more mature phase of growth, characterized by eventually larger market share for the bigger players, less cutthroat pricing and scale economies that should once again attract strong investor interest.

That scenario is likely to play out over the course of 2009 and 2010. And with share prices of the strongest players 50% to 80% from their peak, long-term investors might want to get into the strongest names ahead of this shakeout.

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David Sterman has been an equity analyst and financial journalist for 15 years, most recently serving as Director of Research at Jesup & Lamont Securities.